Why Bengt Holmstrom is An Economist You Should Know

In the economic community, Bengt Holmstrom’s innovative research is well known. To everyone else, the results of his work have yielded a better understanding of some issues of daily importance. From workplace incentives to corporate governance and the financial crisis, Holmstrom has developed new ideas about subjects that deserve our attention. And if some of those ideas seem radical, it’s because he’s just listening to the models.

Holmstrom’s path to becoming one of the world’s leading economists on workplace incentives  was an uncommon one.  In the early 1970s, Holmstrom was working in operations research for a conglomerate in his native Finland. Computers were beginning to enter the workplace, and Holmstrom was tasked with designing how companies could improve planning efficiency through the new technology. The commonly held belief was that computers would naturally improve planning and productivity. But Holmstrom found a problem.  How could computers possibly help productivity if they were not processing the information that incentivizes workers to be productive?

Seeing the flaws in the incentive process within the firm, Holmstrom scrapped the computer analysis.

“I said, ‘this is meaningless.’ We are solving a technical problem, but the real problem is about getting people to provide information in the right way and getting to make the right judgments for themselves,” he said in a recent interview from his office at MIT.

Soon after, Holmstrom went to Stanford on a Fulbright grant. A trip that was intended to be a sabbatical from his job in operations research turned into a nearly 40-year career as an academic and economist.

Holmstrom has taught business and economics at Northwestern, Yale and MIT, where he’s been an economics professor since 1994, but looks back on his private sector experience as one of the most important times in his career.

“That two year experience was very influential. It still is,” he says. “That is perhaps one of the advantages I had that I actually had seen how these firms operate, and how these incentive problems come about.”

For his innovative work with incentives and other areas including, most recently, his research on liquidity in money markets during the financial crisis, Holmstrom is today being awarded the 2013 CME Group – MSRI Prize in Innovative Quantitative Applications.


The CME Group-MSRI Prize

Incentive Models

To Holmstrom, the study of incentives in the workplace was a topic that “seemed wide open for modeling and analysis in economics,” and led him to challenge some of the early research on workplace incentive models – or moral hazard, as it’s known in economic terms – that focused on strictly performance-based incentives.

Those who have not heard of Holmstrom’s moral hazard research are likely familiar with some of its results. In research with Paul Milgrom, he was among the first to discover the importance of multi-tasking in analyzing how employees respond to incentives.

The understanding that people can engage in a lot of different activities is now seen as critical in setting incentives for all kinds of professions.

Stemming from that insight, Holmstrom came to a more radical finding: bureaucracy and what he calls low-powered incentives actually have merit.  The idea goes that smaller, weaker financial incentives encourage employee cooperation and help bring more subtle motivations  to the surface, like company culture and morale. But weak incentives also require restrictions on what employees should do and can do. A well-formed bureaucracy is an essential  part of the overall incentive design in this environment, he says.

Ultimately, his models suggested that the new-found enthusiasm for performance-based incentives had shortcomings, and that rules and regulations  on how to perform tasks still matter greatly.

Holmstrom also studied corporate governance in the wake of several corporate scandals in the early 2000s.

He has argued that while there were structural flaws in the design of executive compensation, blaming stock options plans, as was common at the time, was “a shallow diagnosis” of the cause.  In work with Steve Kaplan of the University of Chicago, Holmstrom determined that the focus on shareholder value that emerged in the 90s and 2000s led to executive incentives that placed too much weight on short, rather than long-term performance.

“When Enron happened, regulators could have corrected these design flaws but they focused on entirely the wrong thing in my view,” he says. “They blamed options in general, when the problem was simply that the options were allowed to vest too quickly.”


The Financial Crisis and Liquidity

In 2010, Holmstrom co-authored a book with Jean Tirole (a fellow MSRI Prize winner) called Inside and Outside Liquidity, which focused on the availability of safe assets during the financial crisis.

Their analysis challenged the commonly held view that taxpayers should never have to bail out banks. When there’s a panic and private firms are not able to raise enough money, government has the ability to provide liquidity that keeps borrowing costs for firms and people at a manageable level, according to Holmstrom and Tirole.

In other research, he has argued against the view that a lack of transparency in money markets caused the crisis.

“Money markets are opaque by design. Their perceived safety does not stem from providing detailed information to the general investor,” he says. “They are made safe by backing up debt claims with sufficient collateral.”

Money markets are based on trust, not rich and timely information, according to Holmstrom. In his view,  the financial crisis occurred when the perceived value of collateral dropped enough to make investors lose their trust and demand more information about the underlying collateral.

“Liquidity is a matter of perception,” Holmstrom says. ”Beliefs can shift quickly and this is what makes the management of economy wide liquidity so difficult.”


Conversation Partners

Though he became an economist after gaining practical experience, it is Holmstrom’s dedication to following his theoretical models that have led him to groundbreaking ideas.

“Models are sort of conversation partners. You’re asking questions of the models and the models answer,” he says. “The importance of theory is to understand exactly how the model thinks. Because then it becomes an understandable conversation partner, and  it can shed light on the questions.”

In addition to his research, he continues to teach in the economics department at MIT, always relying on a chalkboard and discussion. Never slides.

“I personally despise slides because they kind of tie me to a track, and they tempt me not to prepare as well,” he says.

But if the methods by which students learn in his classroom has not changed much over his career, the content of what they’re learning certainly has.

“The basic questions in economics tend to be the same. They come up with alternative answers or different perspectives, but on the whole the questions are the same,” he says. “The nature of the answers and the approaches make advances all the time, and that’s how we deepen our understanding.”

Read More:

MSRI Prize: Robert Shiller Keeps Innovating 

Evan Peterson is director of corporate marketing at CME Group and managing editor of OpenMarkets.

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