First, lets acknowledge this is an excellent choice. It is an excellent choice because of the substantive issues Hart and Holmstrom put on the table for economists to grapple with, it is an excellent choice because it signals the importance of economic theory in working through critical issues of practical importance, and, finally, it is an excellent choice because these two thinkers are brilliant and their contributions are worthy of serious study by all students of economics.
We live in an imperfect world populated by imperfect individuals who must somehow come together to cooperate to realize the gains from specialization in production and mutually beneficial exchange. To achieve this, various institutions have been crafted, evolved, and tinkered with so groups can align incentives and mobilize dispersed knowledge. And here is the issue, incentives are necessary and they are tricky. Systems of rewards and penalties that may be functional in one environment may prove completely dysfunctional in others. Managing incentives is a dynamic problem and requires constant adaptation to changing circumstances, adjustment to new environments, and general coping with the messy world that we humans occupy. Hart and Holmstrom (along with their co-authors such as Sandy Grossman) has published the most important papers during my professional career (1988-today) on these issues. To get a sense of the substantive issues that have tackled in their various writings see Tyler Cowen's post on Hart and Holmstrom, and Peter Klein's excellent discussion of their work.
Second, lets acknowledge that they didn't invent the field of the study of managing incentives. In fact, their work is a continuation of much of the thinking laid out by previous mainline economic thinkers who were awarded the Nobel, such as Hayek, Buchanan, Coase, Ostrom, but of course also the Mechanism Design theorists such as Hurwicz, Myerson and Maskin, the Organizational Theorists such as Simon and Williamson, and the Information Theorists such as Stigler and Stiglitz. There is imperfect information, there are constraints on transactions, and there are institutions to be crafted and tested in practice as to whether they are effective at aligning incentives, monitoring behavior, and metering performance. There are also "games within the games" played inside these nested institutions of a modern complex society as markets, firms, law, politics, and society interact with one another and are not ever truly encountered in isolation of the other.
So if you boil down the basic insights of Hart and Holmstrom, you will see that Adam Smith and David Hume raised similar questions, as did JB Say and JS Mill in the 19th century and Wicksteed, Mises and Knight in the first half of the 20th century. In the second half of the 20th century, besides the thinkers already mentioned above that have been honored to have received the Nobel, 2 names stand out that should have received this prize in my mind --- Armen Alchian and Harold Demsetz. In fact, it is hard to imagine the modern theory of the firm developing without the insights of Alchian and Demsetz's classic 1972 AER paper "Production, Information Costs, and Economic Organization."
So is there a sort of miscarriage of scholarly justice in the passing over of Armen Alchian during his lifetime, and the continuing overlooking of the aging Harold Demsetz by the Nobel committee right now?
Of course there is, but rather than express outrage, I want to offer an explanation that I hope gives pause to some within the broadly speaking coalition of property rights economists, law-and-economics scholars, public choice political economists and market process and entrepreneurship theorists. If this coalition of intellectual traditions is going to have the impact it should have, in my opinion, then it is going to have to reconceptualize the way it is going to engage the scientific community of economists and social scientists. There must be a serious re-engagement with the Buchanan type question of "What Should Economists Do?" and perhaps an even deeper exploration into the insights on the nature of economic science as laid out by Mises, Knight, and Hayek.
In a very colloquial way science is said to progress in the following way: Stage 1 -- what do you think; Stage 2 -- what do you know; Stage 3 --what can you prove. In the 20th century, a strange intellectual alliance formed between Statism and Scientism (this alliance was the hallmark of the progressive era ideology and we have never fully escaped its stranglehold). Scientism itself was based on an intimate relationship between formalism and empiricism. Formalism argued that due to the ambiguities of natural language where the same words could mean different things and the different words could mean the same thing, science would never progress beyond Stage 1 -- what do you think. This stage is critical for getting the intuition -- the insight -- but it will remain immature unless forced to be formally stated where it may have the possibility to reach Stage 3 and be considered a real contribution to Science. But in translating natural language to formal language of mathematics, theorists of the social world had to abstract from a variety of nuances that only natural language can capture. Formal statements can ensure syntactic clarity, not necessarily semantic clarity (this point is something to stress for another time). The full on adoption of the formal language of mathematical economics has costs as well as some perceived benefits that we must bring out into the open in our professional discourse. What happens in economic theory by mid-century due to the formalist revolution is a complete disregard for logical soundness in our theoretical derivations, and instead an exclusive striving for logical validity in the models being developed. What ties these models down and prevents them from being merely arbitrary and free floating abstractions, is that simultaneously with this move there was the advancement in sophisticated techniques of statistical testing in economics. Economics was transformed from a branch of moral philosophy and the field of political economy to a science of "model and measure" and a form of expert guided engineering of economic systems. This self-image fit well with both desire to manage macroeconomics and regulate microeconomics, and of course it fit well with the more ambitious efforts of nationalization and planning. But the main point I want to stress is the need, and more importantly the ability, to tie down the logically valid models to reality through some reliable procedure of sorting through the unlimited array of possible 'model worlds' to select out only those that were empirically significant for this world in which we occupy as human beings. But such unambiguous testing procedures are absent even in physics as Pierre Duhem and Willard Quine respectively demonstrated. So what procedure will do the job of the necessary sorting and thus tying of abstractions so they don't become mere flights of fancy?
Well, unfortunately, economists once the alliance between Statism and Scientism was forged and the profession developed the way it did -- see Hayek's Nobel Prize address on this --- they will not let go of the Scientism even in the wake of developments in the philosophy of science. They aren't always Statist, but 99% of them continue to follow Scientism, and this has huge consequences for why some theorists are acknowledged as contributors and others are destined always to be viewed as perhaps brilliant and insightful but ultimately stuck at an immature stage of scientific development --- Stage 1 -- what do you think, and never capable of moving to Stage 2, let alone the ultimate Stage 3 of what can you prove. Stage 3 is for that rare contribution that can be rigorously stated and then reliably tested against the data. Stage 3 is for Nobel Prizes, Stage 1 can inspire, can point in right directions, can be gratefully acknowledge as part of a unusual and great wisdom of the pre-scientific era. But what if in the sciences of man, this depiction of Stage 3 is actually a false image? As Hayek said, the contributions that appear the most scientific may in fact be the least. And, perhaps those that appear least scientific are in fact the most.
This is the strange fate of Austrian economics and with it the alliance with property rights (Alchian), public choice (Buchanan), and law-and-economics (Coase). The economics of Mises, Hayek and Kirzner -- the modern Austrian School of Economics -- represents a methodological, analytical, and ideological challenge to the mainstream practice in economic science. It is a consistent and persistent critic of the alliance between Statism and Scientism of the mainstream, and it stands in this opposition from the firm position of the mainline of economic thought from Adam Smith onwards. Yet, post 1950, the Austrians could forge alliances with variants of anti-Statism within economics, but they tended to be advocates of Scientism, so the alliance would ultimately break down. At other times, Austrians would forge alliances with anti-Scientism within economics, but they tended to be advocates of Statism, so the alliance would eventually break down. Rare is the critic of both Statism and Scientism -- James Buchanan, Ronald Coase and Elinor Ostrom stand out among the Nobelists -- so those alliances are deep and every lasting.
Alchian (and Demsetz) are victims of Scientism, their work is categorized at Stage 1 -- a brilliant and insightful intuition. Kirzner's work on entrepreneurship is similarly categorized in its most generous rendering by current practitioners. In the current methodological climate, the ideological priors of some might suggest that certain theorists had insights that we should acknowledge, and this might even lead to looking at those insights for analytical inspiration. But the earlier efforts will be dismissed as having not asked or answered the question in a rigorous enough (as if this isn't an ambiguous term itself) manner to warrant scientific merit. These earlier thinkers may even be dubbed "scholars" as opposed to "scientists", and in a culture that demands scientists that folks is an insult.
So my message is to those in the broad coalition of property rights, public choice, law-and-economics, and market process economics if you are outraged by the intellectual injustice to Armen Alchian and Harold Demsetz as many seem to be, it is time to wake up to this fact of the culture of contemporary economics and to inform yourself about the methodological stakes in the sciences of man. Economics cannot successfully achieve the scientific goals it set out to achieve mid-20th century with the move to "model and measure". It can succeed in sustaining itself and advancing itself as a profession, but that is different than the intellectual promise that was made, and we have to ask at what cost does this self-sustaining profession and its prestige come with. Intellectually, I would argue it is the pushing to the background the insight and wisdoms of the mainline teaching of economics from Adam Smith onwards about how productive specialization, mutually beneficial exchange and peaceful social cooperation can result among free people via institutional arrangements that enable them to live better together than they ever could in isolation. We live in an imperfect world populated by imperfect human beings and we adopt imperfect institutions that attempt to enable us to cope with our imperfect existence and thus need to be constantly adapting to changing circumstances and adjusting of multiple margins to aid us to succeed in our efforts through time. The world is messy, but it is also beautiful in this messyness as human beings and human organizations are so creative in their adaptability and adjustments in the face of the constraints on transactions. We are, after all, constantly alert to that which is in our interest to be alert to -- it is what makes us human actors, as opposed to automatons -- and we are capable of learning, of discovering, or exercising judgment over, alternative courses of action that attempt to improve our situation. Ostrom wanted social scientists to study the bottom-up constitutional crafstmanship of communities in their efforts to address tension and conflicts over resource use, and Coase wanted economists and lawyers to study contracts as the human historical record of such efforts to organize exchange and production and cope with the real constraints on transactions so that "deals could in fact be brokered", and of course Buchanan stressed throughout his career that economics was best conceived of as a discipline that studied exchange relationships and the institutions within which those relationships are formed, sustained and at times fall apart.
Hart and Holmstrom are certainly very worthy winners of the Nobel Prize -- very worthy in my opinion -- but the overlooking of Alchian and Demsetz is regrettable. It is, however, understandable. It is a methodological issue, and unless the methodological issue is tackled the analytical and ideological issues will continue to fail to forge a sustainable coalition against the alliance of Statism and Scientism that has a stranglehold on the soul of the discipline of economics.
To conclude let me point to Israel Kirzner's preface to Mises's The Ultimate Foundations of Economic Science as I believe the connection between the methodological, analytical and ideological positions are nowhere as clearly laid out, and the reasons why the methodological battle must be fought against all opposition if there is to be any hope of change to the intellectual landscape.
This work gives us, in a real sense, the final words of which Mises, economist, philosopher, and lover of liberty, had to deliver himself at the close of his life's work.
It should not, therefore, be a matter for surprise that this is a book that was clearly written with enormous passion. Although many of the themes dealt with were themes on which Mises had dwelt in earlier works, here we find them drawn together in a manifesto passionately proclaiming the true character of economics. He dauntlessly defended its epistemological foundations from the attacks of its detractors, disdainfully dismissing the pretensions of philosophies of science built solidly on abysmal ignorance of the teachings of economics.
For decades Mises had patiently and tirelessly developed his system of social thought. He did this during an age in which the tide of philosophical fashion was, to say the least, not running in his favor. Despite the ascendancy of epistemological views that rendered Mises' science of human action grossly unacceptable to the philosophers of his time, despite fashionable methodological innovations in economics that made Mises'own economics appear to his critics as an obscurantist obstacle to scientific advance, despite ideological currents that led to Mises' policy conclusions being set down as both benighted and reactionary — despite all this discouragement and disparagement, Mises never faltered. The passion that suffuses the present work provides an insight into what it was that kept Mises writing and teaching during those bitter decades of intellectual isolation.
Indeed the ideas on which Mises built this book are quintessential to his whole view of economics and of the social sciences in general. Economics, Mises explained again and again, is a discipline the character of which differs drastically from that of the natural sciences. Once one has thoroughly mastered the teachings of economics, Mises argued, it becomes apparent that the science does not fit into the narrow epistemological schema developed by philosophers whose horizons extended no further than the physical sciences. It was this realization that led Mises into his powerful attack on the dogmas of logical and empirical positivism. The shallowness of these dogmas, Mises maintained, is to be perceived not merely on philosophical grounds; their bankruptcy emerges with clarity from the theorems of economics, properly understood. Conversely, Mises pointed out, the preconceptions of positivist writers have been responsible for unwarranted attacks on economics itself.
Mises directed a withering barrage against the illegitimate extension to the realm of social phenomena of the methods and modes of thought appropriate only to the natural sciences. In human affairs, he insisted, we cannot dispense with the category of the mind, with reason, with purpose, and with valuation. To attempt to grapple with the phenomena of society without recognizing the role of purposeful, rational individual human action is a vain and misguided endeavor.
But it was not merely the willful blindness displayed by positivist thought toward human purpose that excited Mises' passionate attack. Mises saw the denial of economics as an alarming threat to a free society and to Western civilization. It is economics that is able to demonstrate the social advantages of the unhampered market. The validity of these demonstrations rests heavily on precisely those insights into individual human action that positivist thought treats, in effect, as meaningless nonsense. What inspired Mises' vigorous and spirited crusade against the philosophic underpinnings of an economics not founded on human purposefulness was more than the scientist's passion for truth, it was his profound concern for the preservation of human freedom and dignity. So it is this, Mises' last book, that provides a glimpse into the most fundamental — the "ultimate" — motives responsible for Mises' lifelong dedication as scientist and scholar. Let there be no misunderstanding, however. Our "human" vision of Mises the man, passionately and personally concerned for the future of the free society, is by no means inconsistent with the image of Mises as the austere, impassive, value-free scientist. Mises, as is well known, was a jealous guardian of the Wertfreiheit of science, and of economics in particular. The conclusions of economics, Mises insisted again and again, do not reflect the interests and concerns of the economist. They deal strictly and impartially with the degree to which the goals of the individuals in society are furthered or obstructed by particular policies or institutional arrangements.
Mises would surely have conceded that his lifelong pursuit and teaching of economics was motivated by values, themselves necessarily outside the scope of science. Certainly these values included both the intellectual's unreasoned passion for truth and the yearning of the lover of liberty for the free society. But Mises would have dismissed with proud (and deserved) contempt any questioning of the disinterestedness of his scientific conclusions. Precisely because he believed that economic science has a crucial role to play in the struggle for freedom, Mises saw how necessary it is for the economist to be incorruptible in his disinterested pursuit of scientific truth. It is necessary for the scientist to acknowledge findings that seem to run counter to his own intellectual interests with the same candor and openness with which he announces conclusions that he views as more congenial to his own values. If economics is to fulfill its wholesome potential in the battle of ideas and ideologies, this can be made possible only by adhering rigorously to standards of intellectual honesty and objectivity impervious to corruption of any kind. Only in this way can we understand the apparently imperturbable calm with which Mises continued his own scientific work despite decades of inglorious academic neglect. Mises' austere scientific Wertfreiheit drew its source from the very passion with which he held to his basic, convictions.