By William K. Black
February 27, 2017 Bloomington, MN
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. Eugene Fama, Jean Tirole, Oliver Hart, and Bengt Holmström exemplify this pattern. This series of articles discusses the joint award in 2016 to Hart and Holmström. In this introduction to the series, I outline the major errors that I will address in this series.
The major errors fall into several categories. The awards, and the committee’s explanation for the awards, give us the ability to look at how the committee thinks of economics. The committee’s message is one of complacency. Economics is progressing brilliantly and now understands the key things that can go wrong in the economy and has developed optimal solutions to those problems. Given economists’ catastrophic policy proposals and predictive failures that were central to the financial crisis that is an extraordinary claim. At least one of two things must be true. Either CEOs are churlishly refusing to implement these wondrous policies, or those policies are disastrous rather than wondrous. This question never occurs to the committee. The committee is not aware of the paradox that at the same time (according to the committee’s fairy tales) economists were “taming the large corporation” and creating “optimal” CEO compensation contracts and governance that supposedly tame the CEO, the real world was going in the opposite direction. The policies pushed by the 2016 Laureates helped create the criminogenic environment that produced unprecedented levels of elite CEO frauds that hyper-inflated multiple bubbles, drove the global financial crisis, and produced the Great Recession.
Complacency is an important ingredient to our worst failures. The great truth is the saying: “it is not the things that you do not know that produce disaster – it is the things that you do know, but are not true, that produce disaster.”
If CEOs refused to adopt the optimal policies, that begs the question whether Hart and Holmström spent from 1980-2008 trying to warn the public that a disaster was going to occur because of the churlish CEOs. As I will show, they did the opposite. They were fierce opponents of financial regulatory reforms. Holmström, even at the time of receiving his award, was sure that CEO compensation was not excessive. What we are seeing is the ideological blinders inflicted by training as a neoclassical economist common to the Laureates and the committee that selects them.
The committee and the Laureates are at their weakest in what they claim to be their greatest strength – their primitive and ideological assumptions about incentives. I will address four critical errors about incentives exemplified by the 2016 joint award. 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.” Parents give up their lives for their children and spouses.
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.
No CEO wants to be the CEO of the next Enron. And no board member wants to be on the board of the next Enron (Holmström & Kaplan 2003: 22).
Their assertion may seem obvious to the reader, but read in context, the assertion was not that no CEO wants to be prosecuted successfully and face long imprisonment. The authors were asserting that no CEO wants to lead a fraud and no board member wants to be on the board of a fraud. That is not true and the assertion is preposterous as a matter of reality and neoclassical economic theory. Hundreds of thousands of CEOs around the world would love to run a massive fraud – as long as they could avoid successful prosecution and the claw back of their fraud proceeds. The twin “dystopian” economic assumptions of self-interest and rationality require the authors to assume that all CEOs “want to be the CEO of the next Enron.” They just want to get away with it. (Criminologists have never gone to such extremes in our assumptions.) Neoclassical economists cannot see CEOs as criminals. CEOs are their heroes (and funders).
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.
I conclude the series by showing how these neoclassical myths persist, and receive the field’s top awards, despite their falsification. I show how the literature in other fields has falsified the myths. I show the predictive errors that have falsified the myths. I even show how other Nobel Laureates have falsified the myths. Holmström, Hart, and the Swedish committee finesse this problem by ignoring the work of George Akerlof and Paul Romer and scholars in other fields.