We are market strategists and investors with a diverse range of views on the major political issues.  One thing we all do share here at Bespoke is a love of economic theory and analyzing data.  To that end, we thought we’d look at one of the dominant political themes, which also happens to be one that is likely to affect the economy and stock markets: Free Trade vs. Fair Trade.  One of the very few topics that has near unanimous agreement among economists of all political persuasions is that free trade is beneficial to all parties. In fact, you can find this view espoused by both Milton Friedman and Paul Krugman.  Yet, in the political process, we hear from leading candidates on both the right and left that our trade deals are terrible and are not working for American workers.  From a macroeconomic theory perspective, the politicians are wrong and the economists are right.  However, we thought we’d look at whether or not another field of economics, Game Theory, has anything to say about this topic.  If you look at trade agreements as a multi-player “game” in which each country negotiates towards the best possible outcome for itself, do “Fair Trade” politicians have an argument to make?  Let’s look at a simplified example:

On a scale from 1 to 10, with 1 being the most free and 10 being the most protectionist, let us stipulate that the United States is currently a 3 out 10 and the rest of the world (“ROW”) is an 8 out of 10, leaving us a starting point of 3/8 (US/ROW), with 3 + 8 = 11.  Anyone can quibble with this starting point assumption, but let us just assume this for example purposes. The ideal outcome would be to get to 1/1, in which 1 + 1 = 2, in which all barriers to trade are removed.  However, the economists would tell you (rightly in our view) that even getting to 2/8 would be an improvement (i.e. a unilateral move by the US to lower barriers to trade even if ROW does nothing) because 2 + 8 = 10, which is less than the starting point of 11.

The “Fair Trade” politicians are arguing that our trade deals should reflect the reality that the US is already starting at a “more free” point and thus it should be on the ROW leaders to lower barriers to drive improvements in the overall trade environment.  This is purely a negotiating stance and thus Game Theory provides us better answers than Macroeconomics.  How do we get a “great deal” as one particular candidate might phrase it?

One possible way is to start off the negotiations with extremely aggressive demands that include a credible threat that the US will raise its barriers to trade considerably if the ROW does not agree to lower barriers. (Stop us if this sounds familiar). In the decision tree below, we sketch one of the (admittedly many possible) approaches the US and ROW could take in a simple 3 step negotiation. In this decision tree, we assume the US makes an opening offer, the ROW responds and then the US decides whether to accept or reject the response. Note: this is an extremely simplified representation of a negotiation, and we have purposely left out many other paths down the tree (including, most notably, that there are likely to be many more rounds of negotiation).

In the decision tree above, the starting point is (as we stipulated) a position of 3/8 (US/ROW). In the opening offer, the US can choose:

  • Offer 1(a): We want the barriers to trade to be immediately equalized at a level 2 out of 10 (the offer) and if they are not, we are going to raise our barriers to a 9 out of 10 (the threat).
  • Offer 1(b): We want to move towards lower barriers for the benefit of everyone and we are willing to lower our barriers to a 1 or 2 (the offer) if you will lower your barriers as well (no threat involved).

In the next step down the decision tree, the ROW Leaders can respond in kind:

  • Offer 1(a):
    • Response Offer 2(a): We will not be bullied and our barriers will remain.
    • Response Offer 2(b): We will lower our barriers considerably to match the levels of the US.
  • Offer 1(b):
    • Response Offer 2(c): We will lower our barriers a small amount if the US will do the same.
    • Response Offer 2(d): Thanks, but we’re not planning to change our policies, but you go ahead and lower yours if you think it will benefit everyone to do so.

As can be seen using backward induction (in which we start with the outcome and work our way backwards), there are three outcomes in which the overall “score” is lowered and thus the world becomes “more free.” However, there is only one outcome (that ends with 3/3 for a total of 6) on the tree in which the score is lowered AND the ROW bears the cost of the reduction in trade barriers.  And as can be seen, it starts with the US taking an extremely aggressive and credible stance in its opening offer.

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