Research at Chicago GSB
Sutton: The reason I wanted to come to Chicago GSB for my sabbatical is that it’s such a powerhouse of economics. The range of activity going on here is amazing. I’m interested in the theory of organizations, and there’s an unparalleled level of interest in that topic here.

The best thing about this environment is the way in which discussion takes place. The seminar series at Chicago is known throughout the profession for its “liveliness.” Here, a seminar is an ongoing, detailed discussion. People want to leave a seminar knowing whether or not they really agree with what’s being said, so you get an intensity of engagement that is really great fun.

Holmstrom: I have always liked the University of Chicago, and this visit has certainly reinforced that feeling. After finishing my chairmanship of the economics department at MIT, I wanted to visit several universities during my sabbatical, beginning with Chicago. I knew this to be an intense, exciting place. The fact that there are young, interesting people here matters especially, because the excitement usually comes from the younger generation.

Current Research
Sutton: I’m interested in understanding firms’ capabilities and how firms interact in the markets given the capabilities they’ve built up. I’m trying to reduce these kinds of ideas to Economics 101 by saying, “Well, how would you describe a firm’s capability? How would you model that?”and so on.

The practical payoff to this approach is it leads us to different and richer ways of looking at practical questions like the globalization process. What kinds of mechanisms come into play when you liberalize global markets?

The nitty-gritty counterpart of the theoretical investigation means that I spend a lot of time walking around India and China looking at automobile plants, measuring quality and productivity levels. I’m trying to come to grips with the way in which the knowledge involved in reaching world class standards is being transferred, and through what channels. What are the incentives for firms to make that kind of transfer of knowledge? And what are the implications for developing countries and the Western world?

Holmstrom: During my time here, I have lectured on liquidity as a way to refine my ideas for a monograph that I’m writing with Jean Tirole. Following [Chicago GSB’s] Doug Diamond’s seminal work, we view liquidity as a form of insurance—firms demand liquidity to insure themselves against future credit rationing.

One of our main insights is that the supply of liquidity is constrained by the amount of corporate income that can be pledged. Economies with a weak system of corporate governance or poorly developed financial markets are more likely to encounter liquidity shortages. This may explain why China and other fast-growing, developing countries like to invest in the U.S. They come here, even after the corporate scandals, because the U.S. financial markets are deep and reliable.

If this view is right, which seems to become more widely accepted, much of the U.S. current account deficit is the result of strong global demand for U.S. savings and risk sharing instruments rather than reckless U.S. consumer spending.

Sutton on Globalization
Sutton: In the models I work with, a firm’s key attributes are its level of productivity and its level of quality, in the sense of the technical performance of its products. In terms of conventional international trade models, having a shortfall in terms of your productivity is not such a big deal because having sufficiently low wages in your country can offset that in a way that brings you into world markets.

Quality is harder. If you fall below a certain threshold in terms of your relative level of quality vis-à-vis your international rivals, you simply can’t sell at all. So there’s a rather vicious selection effect that comes into play once you liberalize.

The immediate impact of globalization involves the wiping out of a whole tier of firms and industries in countries that are in the middle stages of industrialization (“Phase 1”). What comes on the coattails of that, however, are large wage differentials between countries that have very high levels of capability and countries capable of developing such levels. This sets into play very strong incentive effects for multinational companies to transfer capabilities, whether through foreign direct investment, outsourcing, or other channels (“Phase 2”).

What’s remarkable is that when you’re looking at practices across different industries, the speed and effectiveness of those transfers varies hugely. For example, in the automotive component industry, the international standardization of methods of production has come at an astonishingly fast rate. In both India and China from the mid-1990s onwards, car firms and components suppliers moved in seven or eight years from being nowhere to being very close to world-class levels.

At the other extreme, I’ve looked in great detail at the machine tool industry where such transfers are much less effective. Multinational presence is much less evident. Across different industries you get a different profile. But what you can generalize about are the channels of transfer.

When economists started looking at those channels 10 years ago, they looked in the wrong place. Economists expected that multinationals would come in and domestic firms would observe what they were doing and learn how to do it, creating “horizontal transfers” across different industries. That simply didn’t happen.

We know from studying particular industries and from the econometric data, that the interesting activity is happening vertically through the supply chains. Multinationals come into a country like India or China, develop a tier of local suppliers alongside international supply companies that come in, and they play one against the other. It’s very much a case of aligned incentives. It’s in the multinational’s interest to show companies how to do things better in order to use those companies as cheap, high quality sources of supply.

Time and time again you find that the most effective transfer of real capabilities is at the supply-chain level. So that is the second phase of the process, and that’s what we’re very much in the middle of now.

The third and final phase of the process occurs as all these firms face larger global markets, and so have greater incentives to build capability, whether it’s through research and development or other means.

I think over the next 10 years as we see rising income levels in the top quartile of the Indian and Chinese populations, we’ll see a rapid evolution of escalating efforts by companies to build capabilities. The real payoff comes for the Western world as well as for the developing countries in that third phase in the form of enhanced levels of effort in technical improvement, faster rates of growth, and so on. This is the relatively neglected part of the gains from liberalization (“Phase 3”).

I think most of the defenses of globalization have emphasized comparative advantage or intra-industry trade. What I am emphasizing is a third channel that focuses on the selection, transfer, and building of capabilities. This involves the three phases I just outlined. The first phase is really good for the developed world—we get a lot of products of moderate quality at very low prices. The second phase, the adjustment phase in which these transfers occur, that’s the good news for the middle and lower income countries. But that’s a stage at which the capability gap between the advanced and developing countries starts to narrow. That’s where much of the pain of globalization comes from. Building appropriate safeguards through that phase is absolutely essential to the policy process in the advanced industrial economies. Understanding globalization as the action of these three mechanisms, overlapping in time, is the most fruitful way of looking at what’s going on at present.

Holmstrom on Corporate Governance
Holmstrom: A continuing stream of corporate scandals has prompted renewed calls for stronger board oversight and more investor involvement to reign in executives and align their incentives with those of the shareholders. I believe the proposed remedies are based on a shallow diagnosis of the cause of the scandals, the task of boards, and the scope of the governance system.

The scandals revealed significant structural weaknesses in the system, but executive greed and weak boards alone don’t explain why the problems emerged now. The overlooked fact is that the system failed when it was put under strong shareholder pressure.

My work on corporate governance, much of it with [Chicago GSB’s] Steve Kaplan, has aimed at a deeper understanding of how a system that performed so well for so long suddenly ran into such trouble. The role of the shareholder in the corporate drama that has unfolded over the past decade needs to be studied more carefully, not to lay blame, but to find the best way forward. Without the right diagnosis of the underlying factors behind the scandals, we are likely to go wrong soon again.

Why did shareholders suddenly become so active in the 1980s? Steve and I argue that shareholder value emerged in response to big changes in technology and the opening of global markets. Resources had to be reallocated from old to new industries and from national to international markets. CEOs are often ill-suited for that job. They don’t have the expertise to move capital long distances and they don’t like to hand back investor money.

So investors intervened by forcing money out of executive hands through takeovers and by giving executives strong financial incentives to restructure. Drastic changes in incentives always have unforeseeable side effects. The only surprise was their enormous scale. Still, the overall results were pretty impressive. Corporate America restructured itself swiftly and successfully in the 1980s and 1990s.

The decade-long, strong upswing in U.S. productivity should give pause to those who think corporate America has been suffering from a fundamentally flawed governance system. In saying this, I give much credit to the quick regulatory response to the scandals. Such emergency measures should of course be considered part of the overall governance system.

A sound corporate governance system must have the capacity to adjust to emerging problems and changing realities. The challenge is to avoid overreacting to recent events. My concern is that regulatory and legislative reforms, aimed at giving shareholders significant intervention rights, will receive support in the present prosecutorial atmosphere.

A corporate governance system that served us well for over fifty years must have dealt with many of its tasks exceptionally well. There are good reasons why shareholder intervention rights have been limited and why corporate boards have delegated so much authority to executives. Just look at family firms, which often struggle with the opposite problem: the overbearing board.

Before we make a major change in the balance of power between shareholders, boards and executives, we should assess the pros and cons of the current system more carefully. The maximization of shareholder value is not achieved by maximizing shareholder intervention rights. That is one important lesson from modern organization economics.