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The Art of the Deal

Spring 2009 Features

The Art of the Deal

artofthedealThe art of the deal lies in spotting mutual advantage, and avoiding deals based on misunderstanding and misinformation – an increasingly tall order in today’s complex world

The art of the deal lies in structuring a negotiation in which there is a surplus to divide, so that both sides win. There are three principal categories of economic exchange – mutually beneficial trade, trade by mistake, and trade with exploitation.

The mutually beneficial exchange creates a surplus by adding value. I buy a picture from an artist. The artist gets a return on his or her effort. I have an item which gives me more pleasure than it costs.

But sometimes trade is exchange by mistake: the parties are wrong to believe that the exchange generates a surplus, but the trade happens because one or both parties have made errors in valuation. I purchase a used car, thinking it is in better order than it is. Sooner or later, at least one of the parties regrets the transaction, which appeared to be a gain, but was in reality their loss.

In exchange with exploitation, one party gains from trade, the other loses, but the exchange happens anyway because one of the parties is more powerful than the other – as in the Mafia’s offer that you cannot refuse.

Our evolutionary history taught us to be constantly vigilant for exchange by mistake and exchange by exploitation, especially when dealing with strangers. Traders would want our goods because they knew something we did not: they would demand our goods because they commanded force that we did not. Pre-modern economic history translated these fears to international trade. Mercantilists saw global trade as a means by which a stronger political power could enrich itself at the expense of a weaker power.

There were good reasons for the mercantilist position: for most of history, trade was indeed largely based on exploitation and trickery. A victorious army imposed its will on those it had conquered, and helped itself to their assets and their produce. Perhaps the most important contribution of classical economists, epitomized in Adam Smith’s Wealth of Nations, was to demonstrate the potential scope of mutually beneficial exchange relative to exchange by mistake and exchange by exploitation.

Smith and his successors elucidated the potential added value from trade through an appreciation of comparative advantage and the division of labour. Mutually beneficial exchange is possible whenever the two parties have different preferences, resources or capabilities. The division of labour, nationally and internationally, enabled people to effect these gains through specialization.

When the 19-century economist David Ricardo elaborated the theory of competitive advantage, he expected that international trade would proceed from differences in resource endowments – and in his time this was true. But today’s international trade is based more on developed capabilities: Germany exports its skills in precision engineering, the US its achievements in software, China its pool of low-cost labour.

The political and intellectual triumph of the classical economists changed the world. It set the scene for rapid economic growth. Empires would fade away as the costs of maintaining them became prohibitive, when most of the benefits of international trade could be derived from voluntary exchange, rather than appropriation.

But the history of humanity is a history of anarchy and violence, with little of the harmonious order that the classical economists imposed on economic life. So even today, this classical thinking does not come easily to most people. The mercantilist tradition is deeply engrained. The belief that, since the West is so much more powerful politically and militarily than the developing world, trade between North and South necessarily means that the North gains and the South loses, is widespread in both North and South. The fallacy in the argument that China is tricking us out of our money by sending us its goods is obvious, but the fear that the sentiment induces is real. Every recession revives these fears, and the current one is no exception.

Economic power is fundamentally different from political power – and economic power is probably not even a helpful or meaningful concept. Failure to understand the depth of that difference explains the fact that, although expectations of what can be achieved through international economic summits or negotiations are often high, the outcomes are almost always disappointing. It matters to politicians who does or does not receive invitations to the G8 or G20 meetings, but it matters very little to the economies of the countries involved. Excluded small states do not suffer economic damage through their non-inclusion. Perhaps they benefit: they do not even have to pretend to commit to anything.

Few international economic meetings of the past merit more than a footnote in history books. Who now remembers the London Conference of 1933, designed to develop a coordinated response by the Great Powers to the Great Depression? If it is noted at all, it is for the petulance of Roosevelt (who did not bother to come) and for Keynes’ memorable headline in a contribution to the Daily Mail in support of floating, rather than fixed, exchange rates: “President Roosevelt is magnificently right.” Perhaps the only economic conference of lasting import was the Bretton Woods meeting of 1944, which established new international institutions (and which both Roosevelt and Keynes did attend). Many subsequent meetings have had ‘the new Bretton Woods’ as their advance billing: none has come close to living up to it. If the London (G20) Conference of 2009 has any enduring significance, it will also be for its effect on the status of institutions – institutions which have so far had little impact on the development, or resolution, of the crisis.

International economic negotiations do not achieve much because there is little surplus in such deals for political leaders to divide. Mutually beneficial economic exchanges generally take place at the level of the individual business, not as a result of state action. Much the most important issue for political agreement between countries is agreement not to interfere with these individual decisions. This means supporting free trade and eschewing disruptive currency interventions.

But if some people have not learned the lessons of classical economics, others have learned them too well. They claim not just that most private economic exchanges benefit everyone, but that all such exchanges do. This market fundamentalist claim has ruled policy over the last three decades. Perhaps its most important manifestation is in the assertion that global trade in financial markets is as universally benign as global trade in the markets for goods and services. That claim is now questioned – and with good reason.

Voluntary economic exchange may be the result of the likelihood of mutual gain. It may, however, also be the consequence of mistake based on imperfect and typically asymmetric information. In negotiation theory, the distinction between trade for mutual benefit and trade by mistake is often expressed as the difference between private value and common value. In a private value exchange, the parties to the deal agree on what the object is, but disagree on the value to be attached to it. In a common value exchange, the parties to the deal disagree on the exact character of the object, and would, if they agreed on its character, agree on its value.

The significance of this distinction was famously observed through analysis of what became known as the ‘winner’s curse.’ Oil companies were invited to bid for offshore oil blocks. On average, they overpaid. Their successful bids were necessarily those in which their bids were higher than those of their competitors. Generally, these were for the blocks in which the bidder’s geologists had made the most optimistic estimates – more optimistic than those of other companies. The usual reason for the high bids was that the reserve estimates were too high.

The winner’s curse helps explain why mergers and acquisitions are so often disappointing. Companies contemplating a bid will always make errors in assessing the value of the targets. But you are more likely to succeed if you are paying or offering too much than if you are paying or offering too little. Quite generally, people are more likely to buy things when they overestimate their value than when they underestimate that value. This is as true when shopping or hiring as in the context of large-scale commercial negotiations. Wherever there is uncertainty about quality or value, the winner’s curse comes into play: success is often failure.

As the complexity of securitization and derivative products in modern financial markets steadily increased, the financial community rehearsed the argument that the process was one of mutually beneficial exchange; that is, the wider range of trading opportunities allowed for a more and more exact tailoring of risk to the particular preferences and attitudes of particular investors. Mutually beneficial trade, based on differences in preferences, resources and capabilities, explained risk trading in securities markets, just as it explained the trading of goods in conventional markets.

But securities trading is a business in which it is more often true that common values are uncertain than that private values differ greatly. People deal because they make different assessments of the value of the same security. That difference will ultimately be resolved in favour of one party or the other. These are exchanges by mistake. The primary motive for such trade was divergence in the estimates of value attached to instruments that were complex and far from transparent. The inevitable consequence was that such assets were mostly held by people who were too sanguine about their valuation, and with results that they would come to regret.

The debate was epitomized by Alan Greenspan – for whom the sophistication of modern financial instruments was just another elaboration of the benefits of Adam Smith’s division of labour – and Warren Buffett, who characterized such instruments as weapons of mass destruction. But now, as banks try to dispose of what they have come to call the toxic assets on their balance sheet, we know who was right. The art of the deal is knowing when to trade for mutual benefit – and when to refrain from trade which is based on misunderstanding and misinformation.


John Kay is one of Britain’s leading economists and a weekly columnist with the Financial Times. His latest book is The Long and the Short of It.

(Illustration: Keith Negley)

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