In 2016, Profs. Oliver Hart and Bengt Holmstrom won the Nobel Prize in Economics for theoretical models, whose predictions have received validation in experiences of economic agents in all spheres of economic activity.
In their theoretical models, Profs. Hart and Holmstrom predicted that attempts at arrival at ‘perfect contracts’ are, for lack of better terminology, a waste of time.
The intuition for this prediction is very straightforward. If none of the parties to a contract are able to perfectly predict the future, no matter how watertight a contract appears to be today, upon arrival, in future, of any unanticipated events, reasonableness of both agents can imply appropriateness of renegotiation of the contract.
Let us denote capacity for perfect anticipation of all that feasibly could transpire in future, the capacity for Perfect Foresight.
In presence of the normative that none of the parties to any contract have perfect foresight, there does not exist any such thing as a ‘perfect contract’.
In absence of feasibility of a perfect contract, the best that parties to any contract can target, is arrival at a contract, which, conditional on current and anticipated circumstances, is acceptable to both parties. The parties then either can attempt to prespecify conditions that trigger renegotiation, or can predicate renegotiation on future discussions that reveal necessity of renegotiation.
An application of prespecification of conditions, which trigger renegotiation, is indexing of dollar value of a government contract for building of infrastructure, a contract that can span as much as 5 to 10 years, to inflation. Within such a context, in presence of an increase to inflation, a contractor automatically receives larger payments in response to fulfillment of an infrastructure contract.
Whenever a soccer player outperforms his or her contract, and management of the soccer team chooses to renegotiate the preexisting contract — which may not expire for, say, another 18 months — renegotiation has been left open to discussions, and is voluntarily triggered by management of the soccer team in response to performance, which far exceeds expectations. So then, the soccer player earns more over the last 18 months of a preexisting contract, and arrives at a longer-term contract.
Why is a soccer club willing to pay more than it previously had agreed over, say, the last 18 months of a preexisting contract?
In the knowledge that his or her financial future is as secure as reasonably could be expected, a soccer player who has become extremely valuable to a soccer club is able to devote his or her energies to playing of soccer, as opposed to worrying about his or her financial future. Holding all else constant, this outcome is financially beneficial for the soccer club. Consider for instance that the buzz from the resigning, the buzz from recognition of performance of the soccer player can, in of itself, generate increases to revenues. Sales of jerseys of the soccer player, and arrival of new endorsements that benefit the soccer club are a case in point.
The best companies understand what it means to value their best employees, do not treat employees as minions, understand importance of right treatment of employees.
So far, discussions of trade terms that have transpired between the United States and China have been cast as more of a fight, than a renegotiation of terms of trade. Characterization as a fight supposes only entities that are enemies, or entities who do not like each other, but yet have need of each other engage in discussions targeted at renegotiation of terms of a relationship.
This of course is hogwash.
Marriages that not only survive, but that also thrive are built on capacity of the two persons in the marriage to arrive at successful and progressive renegotiations of relationship terms. Renegotiations occur in response to new jobs, new careers, new pregnancies, birth of a child, challenges in extended family, or challenges at work, etc.
Renegotiation is not a bad word, is not a word reserved for discussions between enemies, or people who only tolerate one another.
Used rightly, renegotiations are critical for maintenance of true friendships.
Why have China and the USA arrived at a demand for renegotiation of trade terms? Well, the rationale is simple. As I show in this scientific article, for years China had operated a strategy not well known, but that is robust for expanding an economy, which is, creation of jobs in the export sector of it’s economy.
Whenever jobs are created in the export sector of an economy, there is little or no effect on domestic inflation, such that theoretically speaking, an economy could, potentially, expand ad infinitum, and yet prices of goods and services within the economy are not induced upwards. This state of affairs is the dream outcome desired by all economic policy wonks, which is, full employment that does not induce any significant increase to inflation.
With outsourcing of production trending in the USA, this starting in the 1990s, companies in the United States fed China’s appetite for creation of new jobs within export sectors of it’s economy. Much as any economic expert with integrity could have predicted, however, eventually outsourcing of production from developed countries to developing or emerging countries created imbalance within the world economy, imbalance that remains as yet largely uncorrected.
In presence of the imbalance, for years now, particularly since about 2003, most developed economies of the world have been living off paper money — real estate, hence the 2007–2008 crash of the world economy; securities, hence the 2003 stock market correction, and stock markets that remain highly volatile; or the new fad, ridiculous valuations for app-based businesses. The travesty, of course, is, there as yet does not seem to be any real will to solve the imbalance problem.
The American economy having become somewhat lopsided, the Trump Administration realized, rather correctly, that there was need for a rebalancing of terms of trade that subsist between the USA and China. Necessity of a rebalancing was not created, however, by coercion of America, was created by China’s operation of a sound economic principle, and, however, misguided, America’s desire to outsource most of it’s traditional manufacturing to developing or emerging countries.
In presence of the history, the objective of discussions cannot be characterized as a fight, rather has as target, redistribution of profits that have been created by outsourcing of production, which has exceeded what ought to be appropriate. If outsourcing were at exactly the perfect level, there would not be any demand for renegotiation. In hindsight, however, outsourcing has exceeded what was best for the health of the economy of the United States, with outcome, ex post, a case can be made for renegotiation of terms of trade. If China is reasonable, it will be willing to give up some profits, be willing to extend goodwill to the USA for maintenance of the status quo. If the USA is reasonable, the goal is not alienation of China, rather is a ‘temporary’ redistribution of gains from outsourcing of lots of jobs to China.
When the company, which makes your favorite product authorizes a ‘2 for 1’ special at your local retail store, it is extending goodwill to you, the customer, for contributions to it’s profitability.
It is this same principle that is essence of, ideally, reasonability of willingness of China to agree to a temporary redistribution of profits from outsourcing of jobs to China.
The question then of course is, “how best to arrive at targeted redistribution?” Tariffs increase prices of goods that are imported from China. Simultaneously, tariffs eliminate jobs in China. Unless the USA plans to source substitute goods of similar quality from other countries at cheaper prices, or plans to commence domestic production of such goods, tariffs cannot be characterized to be the right approach to arrival at a redistribution that maintains, or allows for friendship.
Rather than engaging in a fight with China, it is time for America to recognize that renegotiation is not inimical to friendship, that friends can have need of renegotiation for maintenance and invigoration of friendship.
So then, the goal is some temporary redistribution of profits from outsourcing, such that ,for a while at least, America reaps larger benefits from Chinese imports than has been the case in the past, this until a new and better equilibrium can be established.
Ideally, redistributions that are arrived at do not cost existing jobs in China, merely slow down the rate of expansion of the Chinese economy. This, however, cannot be construed to be an imposition on China, rather is natural outcome of the following economic reality.
It cannot be reasonable for China to expect that it can to expand it’s economy, ad infinitum, at expense of other developed economies.
At some point, much like any other developed country, China will have to look inwards for economic growth.
Now that the expansion seems to be hurting the USA, the evidence indicates it is time for the rate of expansion of China’s export sector to experience some natural and appropriate cooling off. If China seeks to maintain same level of growth, it is time to attempt to make up any shortfalls from growth of the domestic economy, growth that may fuel some inflationary pressure. So long as higher inflation remains within some reasonable bound, an increase to inflation is not necessarily a bad outcome for the Chinese economy.
It is time for China and the USA to realize that renegotiation is not inimical to friendship.