How has the Swedish Central Bank’s committee that awards prizes in Economics in honor of Nobel responded to the field’s abject failures regarding the recent financial crisis and the Great Recession? A lesser group would display humility, acknowledge its failures, and promise a fundamental rethink of the field. Neoclassical economists, however, are made of sterner stuff. The committee’s response is to praise the discipline for its theoretical advances and proposed policies related to finance, regulation, and corporate governance. Oliver Hart, and Bengt Holmström exemplify this pattern.
The economics prize is a bit different. It was created by Sweden’s Central Bank in 1969, nearly 75 years later. The award’s real name is the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.” It was not established by Nobel, but supposedly in memory of Nobel. It’s a ruse and a PR trick, and I mean that literally. And it was done completely against the wishes of the Nobel family.
Sweden’s Central Bank quietly snuck it in with all the other Nobel Prizes to give free-market economics for the 1% credibility. One of the Federal Reserve banks explained it succinctly, “Few realize, especially outside of economists, that the prize in economics is not an “official” Nobel. . . . The award for economics came almost 70 years later—bootstrapped to the Nobel in 1968 as a bit of a marketing ploy to celebrate the Bank of Sweden’s 300th anniversary.” Yes, you read that right: “a marketing ploy.”
The Economics Prize has nestled itself in and is awarded as if it were a Nobel Prize. But it’s a PR coup by economists to improve their reputation,” Nobel’s great great nephew Peter Nobel told AFP in 2005, adding that “It’s most often awarded to stock market speculators …. There is nothing to indicate that [Alfred Nobel] would have wanted such a prize.
Members of the Nobel family are among the harshest, most persistent critics of the economics prize, and members of the family have repeatedly called for the prize to be abolished or renamed. In 2001, on the 100th anniversery of the Nobel Prizes, four family members published a letter in the Swedish paper Svenska Dagbladet, arguing that the economics prize degrades and cheapens the real Nobel Prizes. They aren’t the only ones.
Scientists never had much respect for the new economic Nobel prize. In fact, a scientist who headed Nixon’s Science Advisory Committee in 1969, was shocked to learn that economists were even allowed on stage to accept their award with the real Nobel laureates. He was incredulous: “You mean they sat on the platform with you?”
Why economics? To answer that question we have to go back to Sweden in the 1960s.
Around the time the prize was created, Sweden’s banking and business interests were busy trying to ram through various so-called “free-market” economic reforms. Their big objective at the time was to loosen political oversight and control over the country’s central bank. According to Philip Mirowski, a professor at the University of Notre Dame who specializes in the history of economics, the
Bank of Sweden was trying to become more independent of democratic accountability in the late 60s, and there was a big political dispute in Sweden as to whether the bank could have effective political independence. In order to support that position, the bank needed to claim that it had a kind of scientific credibility that was not grounded in political support.
Promoters of central bank independence couched their arguments in the obscure language of neoclassical economic theory of market efficiency. The problem was that few people in Sweden took their neoclassical babble very seriously, and saw their plan for central bank independence for what it was: an attempt to transfer control over economic matters from democratically elected government and place into the hands of big business interests, giving them a free hand in running Sweden’s economy without pesky interference from labor unions, voters and elected officials.
For the first few years, the Swedish Central Bank Prize in Economics went to fairly mainstream and maybe even semi-respectable economists. But after establishing the award as credible and serious, the prizes took a hard turn to the right. Over the next decade, the prize was awarded to the most fanatical supporters of theories that concentrated wealth among the top 1% of industrialized society of our time. At the time of the prizes, neoclassical economics were not fully accepted by the media and political establishment. But the Nobel Prize changed all that. What started as a project to help the Bank of Sweden achieve political independence, ended up boosting the credibility of the most regressive strains of free-market economics, and paving the way for widespread acceptance of libertarian ideology.
The Swedish Riksbank awarded this year’s Nobel prize for economic sciences to Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, for their work improving our understanding of how and why contracts work, and when they can be made to work better.
Their work focuses attention on the necessity of trade-offs in setting contract terms; it is yet another in a series of recent prizes which explores the unavoidable imperfections in many critical markets. Mr Holmstrom’s analyses of insurance contracts describe the inevitable trade-off between the completeness of an insurance contract and the extent to which that contract encourages moral hazard. From an insurance perspective, the co-payments that patients must sometimes make when receiving treatment are a waste; it would be better for people to be able to insure fully. Yet because insurers cannot know that all patients are receiving only the treatment they need and no more, they employ co-payments as a way to lean against the problem of moral hazard: that some people will choose to use much more health care than they need when the pool of all those being insured picks up the bill. A common and important thread in work by Messrs Hart and Holmstrom is the role of power in planning co-operative ventures. Individuals or firms with the ability to hold up arrangements – by withholding their service or the use of a resource they own – wield economic power. That power allows them to capture more of the value generated by a co-operative effort, and potentially to sink it entirely, even if the venture would yield big gains for all participants and society as a whole. Contracts exist to shape power relationships. In some cases, they are there to limit the exercise of hold-up power so that a venture can go forward. In others, they are intended to create or protect certain power relationships in order to encourage good behaviour: workers or firms with the right to exit a relationship, for instance, force other parties to that relationship to take their interests into account. The broader lesson – that power matters – is one economics too often neglects.
The theory holds that the contracting costs between economic units are shaped by the nature of the interaction between them. These costs are not operational costs, such as commission fees or transportation costs. Instead, they stem from the lack of clarity and enforceability of the terms of the interaction and each unit’s dependence on the interaction. And, in the words of today’s prize winners, they cause contracts to be incomplete.
- Constraints on due diligence limit the information available to negotiators.
- Changing technology and markets make it impossible to foresee future contingencies.
- Uncertain project requirements make it impossible to specify all costs and benefits.
- Companies have information and conduct actions that are hidden, intentionally or not.
- The value of some inputs or outputs may be impossible to measure.
- Links to other projects make it hard to isolate costs and benefits of the transaction.
- Weak intellectual property laws prevent a firm from resorting to courts.
- It may be hard to enforce agreements without actually threatening a breakup.
- Dependence on a transaction leads to a risk of being held up.
When managers spot these sorts of problems on the horizon, a deal that potentially will create value may not get done because the contract is bound to be incomplete. The danger is that the contract will not specify how to resolve conflicts in the future. This is because the agreement between the parties does not cover all contingencies, all issues, or all possible states of the world. To govern a partnership successfully, then, you need to manage the gaps in the contract. Traditional management techniques call for command and control in these situations, to respond quickly and decisively to new conditions. But this solution is missing from typical partnerships, most of which are characterized by a sharing of control. It may be a formal joint venture with shared ownership or a looser arrangement whereby one party controls certain parts of the joint project and the other party controls others. So, each partner’s control in these combinations is also incomplete.
Neoclassical economic dogma is that money is the “high power” incentive. Normal humans know that this is preposterous. The highest power incentives are rarely monetary. People give up their lives for others. Some of them do so nominally for “duty, honor, country,” but actually because of the effects of “small unit cohesion.” A second neoclassical dogma is ignoring fraud and predation. The 2016 prizes show how, despite their knowledge of the falsity of the implicit assumption, neoclassical economists repeatedly ignore the manners in which CEOs shape perverse incentives and render the Laureates’ compensation and governance policies criminogenic. A third neoclassical dogma is, implicitly, to assume that perverse incentives do not influence CEOs and those they suborn. Holmström and Steven N. Kaplan’s article about corporate governance in light of the Enron-era frauds unintentionally displayed this third neoclassical dogma about incentives. The fourth dogma is that regulation cannot succeed because it lacks “high power” incentives. Criminologists’ understanding of incentives and how CEOs set and pervert incentives is far more sophisticated than neoclassical economists’ myths about incentives. Criminologists provide the content to how CEOs that predate “rig the system.” Criminologists agree that perverse financial incentives are important contributors to white-collar crime.