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Bengt Holmström - the deal making authority

Together with Oliver Hart, Bengt Holmström receives this year's Nobel economics prize for research on the theory of contracts. We met him to talk about his findings and their importance for the business world.

Bengt Holmström is a pleasant gentleman whose suit fits perfectly. 40 years ago the Finnish-born scientist moved to the United States. The specialty of the soft-spoken and quiet economist is the theory of contracts. Among other things , he's looked into what the ramifications of financial incentives in employment agreements are.

Working as a professor of economics at the Massachusetts Institute of Technology (MIT), he has no personal experience with bonuses. "I have never received a bonus in my lifetime," he said. He usually gets a hike, when another Ivy League University like Harvard tries to lure him away. Because every time this happens, MIT's antidote is a salary increase.

However, extremely performance-oriented salaries were widespread before the outbreak of the global financial crisis. In 2007 alone, then Goldman Sachs CEO Lloyd Blankfein raked in $68 million (64 million euros).

Bengt Holmström emphasizes that the market should determine the level of wages and compensations. He is interested in the structure of contracts and the different ways the signatory parties' interests can be balanced. And he has been comtemplating on the principles of the structure of such contracts since the 1970s, in order to find ways to reward managers for their individual performance. But in most cases, his theories went unheard.

Nobelpreisträger Bengt Holmström und Oliver Hart (picture-alliance/dpa/H. Montgomery)

Has never received a bonus in his lifetime: Bengt Holmström (left) with Oliver Hart

At Goldman Sachs, for example, bonuses were paid right away, before a long-term picture would evolve. "You can rarely see all ramifications of a decision within the same year, " he explains. Holmström recommends limitations on incentive stock options or simply a wait-and-see approach: a part of the bonus gets paid while another part will be put aside. 

According to Holmström, it is rather an ethical question whether it is a good idea to put a ceiling on salaries. But he thinks it is a problem that a moral discussion usually loses sight of the clear structures.

Nokia's long way down

For some time, Holmström could virtually study the workings of top management contracts from the inside. From 1999 to 2012, Holmström was on Nokia's supervisory board. There, he witnessed the rise and fall of the company, which had been the largest mobile phone manufacturer in the world for years until the Finns missed the boat on smartphones. Back then, only short-term success mattered.

Watch video 02:33

Closeup: Economics Nobel winner Bengt Holmström

Was there anything Holmström could have done to steer Nokia in another direction? "We knew that compensations and incentives were overly short-dated," he says. He recalls discussions about salaries and incentives. But in the end it sounds like describing the herd instinct of people residing on executive floors: "A company is bound to what their business consultants say. You don't want to stand out too much. Because otherwise, there will be questions like 'why are you doing this.' That's a general problem of contracts. Contracts have the tendency to be standardized," he explains. If they are different, questions will be asked.

He left Nokia in 2012. Today, he sees even less scope for managers. They were monitored permanently and had to justify their every move. Their contracts, the MIT professor says, should be changed: long-term objectives combined with long-term incentives.

Bengt Holmström has noticed a general loss of trust in listed companies. Their share-holders wanted to have a say, but did not have the proper resources. Because of that, business consultants came into play, but they would follow their own interests.

"Business consultants have a massive incentive problem. They shy away from risks and they don't want to step out of line." Trust in management boards has been lost and managers have even less leeway in decision-making than in the past.

 

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