Chapter 5

Bargaining Theory 101

How Not to Deal with China

We are living in the age of economists—the Age of Larry Summers, as it were. These high priests sit at the right-hand side of presidents and prime ministers, dominate cabinet meetings, and help explain “the economy” to a benighted public. Indeed, they do more. With the advent of Economics Imperialism during the past few decades, economists have confidently utilized their analytical prowess to become spokesmen on topics ranging from date rape, to demography, to financial system reform, and to the pursuit of happiness, not to mention the future of the world economy.

Yet there is a paradox here. Despite the appeal of their models, economists have less and less to say about the most important issues of our time. For these issues are political in nature—indeed political philosophical—not economic. Attacking these problems in a satisfactory manner cannot be achieved with the tools of micro- and macroeconomics. As a result, when economists do discuss such issues as how to prevent welfare state bankruptcy, the results are superficial and piecemeal. Strangely enough, the same can be said of the analyses of most political scientists. Their discipline is highly problematic as it never found a “core model” around which to organize the pastiche of insights it offers, interesting as many of these insights are.

In this chapter, I attempt to offer such a core model, and to apply it to a case study involving the growing rivalry between China and the United States. More specifically, I argue that the root problem of political science has been its failure to adopt as its core model the concept of politics as multilateral bargaining behavior between overlapping interest groups. After all, this is what social life is all about—with a single notable exception: economic behavior within an “invisible hand” market economy where prices coordinate human activity, and where no concept of bargaining is either required or in fact possible. Given today’s absence of a bargaining perspective on matters political, the analyses of today’s most pressing political issues are often half-baked.

For example, consider how little both political scientists and economists have had to say about the central problem confronting most all governments of the West during the next several decades: How can democratically elected governments be prevented from continuing to mortgage our children’s future? This problem is rarely identified in the policy journals or op-ed pages, much less addressed in a serious manner. To be sure, commentators on both the Left and the Right often complain about the future insolvency of many welfare states, but to complain about a problem is not to analyze it, much less solve it. Without the right core model around which to organize our thinking, it is unlikely that much progress will be made in doing so.

The great irony here is that a suitable core model does in fact exist, a model of multilateral bargaining that is ostensibly unknown to most social scientists, and that astonishingly is neither discussed nor referenced in most political science textbooks. The model stems from John F. Nash Jr.’s remarkable theory of bargaining set forth in the early 1950s. Many of you will know of Nash from the book and movie about his life, A Beautiful Mind. In two papers published in 1950 and 1953, Nash posed and deduced an axiomatic solution to the problem of how two people compromise their differences and arrive at a mutually acceptable compromise during bargaining.

Another game theorist, John Harsanyi, would give a much deeper source of support to Nash’s bargaining solution in two papers published in 1956 and 1963. In the second paper, he also extended Nash’s theory to games with any number of players and coalitions. Because of the pioneering work of these two scholars on bargaining theory, it finally became possible to clarify such concepts as “relative power,” “balance of power,” “political economy,” “credible threats,” and “interest group politics.” For this and related work, both Nash and Harsanyi would receive the Nobel Memorial Prize in Economic Sciences in 1994, notwithstanding that neither was an economist proper.1

This chapter has two goals. The first goal is to introduce the Nash-Harsanyi bargaining paradigm in very simple terms. In doing so, I show how this framework makes possible a precise definition of the all-important concept of relative power, and how it advances analytical social science in several other ways as well. Bargaining behavior turns out to be the magnetic north of politics, and the Nash-Harsanyi model is the missing “core model” that could play a unifying role in political science analogous to that played by the law of supply and demand in economics.

The second goal is to apply the Nash-Harsanyi model to the ongoing bargaining game between China and the United States as these two powers begin to duel for global primacy. The analysis here is intended to suggest a new way of thinking about power, conflict, and conflict resolution. The “historically inevitable” loss of power by the United States to China emerges as a half-truth, and the real story lies in the arrant incompetence of the United States in its bargaining with China, as contrasted to the consummate skill of the Chinese in getting what they want from us. This situation can be remedied if the United States (and by extension the West) starts to properly protect its turf rather than yield it time after time to an aggressor. The Nash-Harsanyi logic makes clear how to do so, and why it should be done.

To sum up, there exists an unfortunate and unnecessary imbalance today between res politica and res economica, a distinction apparently introduced by Aristotle. Economics does not and should not rule the roost. Indeed, properly understood, free-market economics turns out to be no more than a limiting special case of multilateral bargaining, as the Nobel laureate Robert Aumann proved formally, in a remarkable result we will review later in this chapter. This confirms Aristotle’s insight that politics trumps economics, and that politics is indeed the master discipline. The time has arrived for this truth to be recognized if we are to forge meaningful solutions to those political problems that are becoming the dominant issues throughout the West.2

The Origins of Economics Imperialism

The phrase “Economics Imperialism” has been in use for nearly three decades. The term was coined by the late economist Kenneth Boulding of the University of Colorado at Boulder. It captures the reality that, of all the social sciences, economics has emerged as the most relevant, most useful, and most rigorous discipline. Its perspective on social behavior and its analytic methods have invaded most every branch of sociology, political science, and social psychology. The success of such books as Freakonomics is proof of this point, as its authors Steven D. Levitt and Stephen Dubner have emphasized. Finally, if any further proof is needed, just consider the surging enrollments in economics and finance courses at major universities worldwide during the past few decades.

The same phenomenon is true in the field of public policy analysis. There was a time when the cabinet of the U.S. president consisted of lawyers, businessmen, political scientists, and economists. Economists in fact were latecomers to the game. It is often forgotten that they were few in number prior to World War II since neither the data nor the theory they needed yet existed. Lawyers dominated policy since the time of President Lincoln, as did gentlemen farmers before that. But this is no longer the case. We are now living in an age when economists such as Martin Feldstein or Lawrence Summers or Ben Bernanke dominate public policy discussions. With their well-honed analytical skills (lacking in other fields), they sound off with credibility on any number of topics, and often have the last word.

But do they deserve such credibility? At a time when ballooning government deficits are issue number one throughout the West, and when the prospect of “red ink as far as the eye can see” is supported by the most reputable of economic projections, can you think of a single economist who has asked, much less answered, the Great Question of the day: “How can we pass a constitutional amendment preventing the government from further mortgaging the future of our children and grandchildren, and in doing so spare the United States further credit downgrades, and potential bankruptcy in the long run?” This is a question of political theory, one that economists understandably are hesitant to address. But since welfare state solvency will be the principal issue for Western democracies during the next 50 years, their specific expertise will become less interesting and less relevant.

Five developments explain the advent of Economics Imperialism:

First, the discipline of economics is indeed highly analytical and rigorous, and this imparts credibility to it.

Second, as a scientific endeavor, economics can both describe and explain a wide range of phenomena. Armed with these capabilities, it can also help to forecast the future. Of course, these forecasts are not always accurate, and it is easy to laugh at them. But it may be better to laugh at the fruitless attempts of physicists to predict where a scrap of paper will land when dropped from five feet above the floor. The “standard error of estimate” of their forecasts is much higher than those of economists predicting the path of the economy! Forecasting is difficult in any field, but that does not render it useless, and economic forecasting has become indispensable in today’s society.

Third, the analytics of economics are not mere abstractions, but are transformed into testable models via the linkage between economic theory and econometrics. In an age when the objectivity of analysis is prized, it helps a policy maker to be able to trot out extensive statistical backup for his case, regardless of how flawed the underlying statistical methodology might be.

Fourth, economics was the first discipline to capture and recognize the all-important concept of “incentives.” When they make decisions, consumers, producers, investors, and indeed politicians respond to given incentives. This point is extremely important for two reasons: (1) the concept of “incentive structure compatibility” is arguably the most important concept ever set forth in analytical social science, and can be utilized to assess the performance and viability of entire social systems (e.g., capitalism versus communism) as I demonstrate in the next chapter; and (2) incentives can be changed by government policy—in particular, changed for the better via superior policies. This second point has permitted economics to be linked to public policy in a very compelling manner. By knowing the consequences of rerigging the incentive structure, a policy analyst can better predict the outcomes of various policy changes, and thus can identify a better policy.

Fifth, beginning students of economics are presented with a powerful analytical model that is as compelling to economics as the law of gravity is to physics: the law of supply and demand. Imagine economics without this core model!

The Contrasting Failure of Political Science

Now contrast these selling points of economics with the state of political science today. To begin with, there is no organizing paradigm or “model” of any kind. The field is often described as unrigorous and mushy. Consider the field of international relations, and journals such as Foreign Affairs. Some very good articles appear, representing the considered views of highly knowledgeable people. But the reader looks in vain for clear, rigorous definitions of concepts such as optimal threats or balance of power or self-interest or rationality. Moreover, crucially important issues of incentive structures are either suppressed or confused. Worse yet, the most fundamental perspective cross-cutting all forms of politics is usually given short shrift, namely “Politics: Who Gets What, When, and How,” the perspective memorably proposed by Harold Laswell back in 1935.

All in all, the paradigm of politics as the process of multilateral bargaining between competing interest groups is either absent from the pages of most political science books and op-ed articles, or else is present in an ambiguous way. Accordingly, a core model centered around bargaining is truly needed.

Why the Paradigm of Economics No Longer Suffices

There are several different reasons why political science can now be viewed as more fundamental than economic science.

First, as economic theorists such as Robert Barro at Harvard have shown, the proper functioning of free market economics is completely dependent upon the assumptions of the rule of law, of nonbribable judges, of sanctity of contract, of transparency, and so forth. That is to say, proper political institutions are a necessary condition for the virtues of a free market system to deliver the outcome society wants, namely an efficient allocation of resources and risk. These underlying institutions come first, and we surely need a rigorous discipline to make sense of these political prerequisites of economics.

Second, the ability of a free market capitalist system to deliver the goods requires much more than the basic institutional setup just described. Specifically, whenever issues of “public goods,” “externalities,” or “imperfect competition” arise, interest groups that are impacted must determine via multilateral bargaining exactly what gets provided to whom, and who is to pay how much of the bill. In a more general global context, issues of coping with misaligned currencies, vast trade imbalances, and theft of intellectual property rights will only be resolved politically via multilateral bargaining between the impacted interest groups. This is part and parcel of a well-functioning capitalist system. Alas, there is no invisible hand to settle these issues without bargaining there is to determine the daily price of fresh produce in the marketplace.

Third, we are living in a world where the price, quantity, and allocation of important commodities like oil were once determined by a free market. But they no longer are. We are now witnessing a dangerous “politicization” of the oil, gas, copper, and other markets. We will see the day when China may well determine the allocation of certain natural resources whose supply they have tied up via long-term bilateral contracts with nations throughout the developing world. Should this occur, then markets per se will no longer allocate resources as they have in the past. This role will have been assumed by bargaining.

Fourth, most of the important issues that could stymie future world growth and precipitate war remain quintessentially political in nature. For starters: Who gets how much water at what price? Who will pay how much for global warming? How much will tomorrow’s youth be taxed to pay for the elderly? How high a tax bill will they be willing to pay before defaulting upon the debt they inherit? What is their threat strategy? Which nations will be “allowed” to go nuclear? The list goes on.

In short, our future will depend upon the quality of governance. But what exactly do we mean by “success in governance?” Is there a yardstick of good governance in politics analogous to that of “efficient resource allocation” in economics? More broadly, is there an organizing paradigm or model that could prove as useful to res politica in the future as the Law of Supply and Demand has proven useful to res economica in the past? Happily, there is. Yet this model is completely unknown to most political scientists and philosophers. As an aside, there is a thriving group of “rational choice theorists” within the political science community who have gone part way in creating analytical models and rendering their discipline more rigorous. Nonetheless, their models are largely silent on the root issue of bargaining power as defined later in this chapter, and are thus somewhat bloodless in my own view. Their principal limitation is that they cannot properly deal with the role of relative intensity of preference in bargaining.3

The Possibility of the Hegemony of Political Science: The Nash-Harsanyi Pluralistic Bargaining Model

In the opinion of scholars familiar with it, the Nash-Harsanyi model of multilateral bargaining is one of the marvels in the history of analytical social science.4 Before its development during the period of 1950–1965, concepts like “power,” “democratic pluralism,” “bargaining equilibrium,” and “balance of power” were problematically elastic concepts lacking precise meaning. Accordingly, such variables could not be measured quantitatively for the purpose of model building. Additionally, without this model, the notion of relative bargaining ability could not be defined. For absent a model predicting an optimal bargaining equilibrium between symmetrically rational and skillful players, the degree to which one player could be said to bargain better than another in the real world could not be determined.

By extension, it was also impossible to assess the relative competence of different governments in striking bargains on behalf of their citizens without the yardstick made possible by an idealized model. For example, how can we assess how incompetent the U.S. government was in permitting Chinese mercantilism to boost employment in China, while costing millions of “good jobs” over here?

The Building Blocks of the Model

The building blocks of the model are players, strategies, payoffs, and preferences. More specifically, we have:

1. The set of n individual players

2. The set of all possible pairs of players that could come face to face with each other in any number of overlapping coalitions that might include them both (you and I are both members of the Sierra Club and of the Classical Music Association)

3. The set of possible coalitions that these players can form and oppose one another (e.g., the environmentalist lobby versus the timber industry)

4. The set of strategies available to each player individually, and available to each and every coalition that might form—including those threat strategies that any individuals and/or coalitions utilize, should negotiations break down and no compromise be reached

5. The resources available to each individual player and to each coalition—including economic and military resources alike

6. The “dividends” each player receives from any coalition he joins—a payoff proportional to his “relative contribution” to each coalition

7. The preferences of each player for what is at stake, including his willingness to take risk in pressing for his demands. This latter feature is often called a player’s “risk tolerance,” and while it is only one type of preference, it plays a very important role in bargaining.5

The Logic Utilized to Arrive at a Rational Bargaining Compromise

Nash modeled bargaining behavior as a two-stage game played by two players. In stage 1, the two players each announce the optimal threat strategies which each would deploy should no compromise be agreed upon during the second-stage game, the bargaining game proper. The “threat payoff” associated with these threat strategies serves as a point of reference whereby each player knows what his fate will be should no deal be reached by the time when the opportunity to bargain further expires. (It is assumed that there is a negotiation expiration date.) A bit further on, I will explain the logic by which each player selects his optimal threat strategy. The impetus propelling each player towards a compromise is that both know that they will end up worse off without an agreement (where they receive only the threat payoff) than with one.

Nash showed that, in every such game, there will be a unique solution, that is, a unique compromise between the players. If the game is a simple one consisting of two players attempting to divide the pie, the solution would represent the agreement whereby player 1 would receive, say, 65 percent of the pie, and player 2 would get 35 percent of it. But why would they not each get 50 percent? What differences between the players cause an unequal outcome to be agreed upon? Nash himself did not really answer this question convincingly as his approach was too abstract to do so, but John Harsanyi did in 1956.6 He modeled the bargaining game as a bargaining process consisting of a sequence of “concessions” by both sides—just as we observe in real life. At first, each player demands most of the pie. “If I don’t get 90 percent, I’ll screw you.” As time goes on, both reach a “sticking point” at which it is irrational for either to concede further, and bargaining stops. This sticking point is the solution in Harsanyi’s model.

For any game, there will be one and only one such sticking point, and it happens to be the Nash solution, arrived at via a very different logic from Nash’s own logic. Harsanyi provided a convincing explanation of why the sticking point would generally be asymmetrical in the sense of awarding an unequal division of the pie to the players. The reason was that the players typically had different preferences towards risk. This reveals itself during bargaining by the fact that a player with less risk aversion than the other is willing to press his demands harder than the other during the process of bargaining. In doing so, he is more willing to run the risk of receiving the threat payoff than the other is. In game theory parlance, his “fear of ruin” is lesser.

The Solution Itself

But where does this process stop? What exactly is the unique sticking point of any game? What makes both players refuse to make further concessions? Harsanyi showed that there is a unique sticking point corresponding to the point in the bargaining process where both players individually have reached their “risk limits.” More specifically, for each player, the loss to himself from a further concession to the other would exactly equal his gain of reduced “fear of ruin” risk that results from making the concession. Once again, fear of ruin risk is simply the risk each player faces of receiving the threat payoff, and of going home empty-handed. In sum, the sticking point is the point where the risk limits of both players are reached, and remarkably this solution is always the Nash solution.7

Harsanyi’s concept here is as subtle as it is powerful. It can be summarized by claiming that pie is awarded in proportion to risk tolerance: Each player will receive a slice of the pie whose size is larger than the other’s slice to the extent that he has a greater tolerance of risk than the other. Interestingly, there is another, newer justification for the same solution: Pie is awarded in inverse proportion to the players’ relative need for it. More specifically, a player will receive a slice larger than the other’s to the extent that he is “less needy” for it than the other. Thus, a player that just ate a hot fudge sundae and is not hungry can bargain down another player who has not eaten, and who has two hungry children to feed. It may not seem “fair” that the needier settles for less, but it is the way of the world. The relative needs version is perhaps the more intuitive of these two rationales for the Nash-Harsanyi solution. No complex concept of risk limits is required. This solution was introduced and shown to be formally equivalent to the Nash solution in 2004.8

The Case of More Than Two Players, and of Coalitions

In 1963, Harsanyi extended the entire Nash-Harsanyi logic to the case of more than two players who were free to form coalitions, indeed “overlapping” or “pluralistic” coalitions. Any player could be a member of as many interest groups as desired. His model was necessarily quite complex, given the need to model rational bargaining behavior both by all possible coalitions, and by all pairs of individuals that confront each other inside and outside of the various coalitions to which they might belong. Here is a simple summary that should prove useful since I will draw on this model later in discussing the United States versus China game.

Like the two-person game solved by Nash, the n-person game consists of two stages. In stage 1, all coalitions form and announce optimal threat strategies against one another. In a corporate labor dispute, the company’s optimal threat might be to fire all workers whereas the workers’ threat might be to go on strike and maximize bad publicity for the company. Then in stage 2, a consensus is arrived at specifying how much of the overall pie each of the players will receive in light of the relative bargaining power of all the coalitions of which he is a member.

The outcome that is reached by all players who bargain in this manner is known as the game’s multilateral bargaining equilibrium. It formalizes previous concepts such as the political scientist David Truman’s notion of “pluralistic politics,” where pluralism reflects the reality that we are all members of different yet sometimes overlapping coalitions advancing the variety of overlapping interests we have as human beings. The outcome that is arrived at will accurately reflect each player’s (and each coalition’s) relative power. But what exactly is each player’s power? Can this be formalized? And how do individuals and coalitions select threats against one another that are credible, much less optimal? What do these terms mean? These are two loose ends to which I now turn. In passing, I will explain the interrelation between free market behavior in economics in which there is no bargaining at all, as opposed to bargaining behavior in general.

Optimal Threat Strategies That Are Credible

As was discussed informally previously, the concept of threat strategies plays an important role in determining the outcome of bargaining. But how does each player (whether an individual or a coalition) determine which of many possible threat strategies is the optimal one? What exactly does “optimal” mean here? And finally, how will his opponent know that this threat is credible—not just a bluff—and thus be effective in orienting the bargaining game? Nash and Harsanyi provided answers to all three questions.

In selecting a threat strategy, each player (and each coalition in the case of n-person games) will want to trade off two different entities, X and Y. X refers to the damage he can do to the other player in selecting his threat. You might think that his optimal threat will be to wreak maximal damage upon the other. But this is incorrect because it ignores the role of Y, which denotes the damage he inflicts upon himself in exercising the threat. Accordingly, a given player (or coalition) will want to select that threat that maximizes the spread between the damage it can inflict less the cost to himself of doing so, that is, the spread X–Y. But the other player (or the opposing coalition) will look at the problem in reverse: He will select a threat strategy maximizing the mirror image spread Y–X.

But as Nash showed, this is equivalent to minimizing X–Y. Thus, the threat selection game between any two players (or coalitions) ends up being a kind of zero-sum “MaxMin” game in which the entity that one party wants to maximize is the entity that the other party wants to minimize. Nash proved that there will always exist a unique pair of threat strategies—one for each player—that solves this MaxMin problem.9 This is true even though the particular threat strategies available to each player are different, as are the potential values of X and Y for each player. This is a remarkable result.

Let me show an intuitively appealing and simple example of this logic at work. Suppose you and I are two neighbors living in wooden houses 50 feet apart. We both get very angry at each other over a dispute concerning my decision as to where to construct a new fence between our houses. We each pull out a box of matches and say to one another, “If I don’t get my way, I will use these to burn down your house.” We would each thus appear to have symmetrical threat power over each other. But this is incorrect. For I remind my neighbor: “The wind always blows from my house towards yours. So if you burn down my house, you will burn down yours as well. The reverse is not true. So stop bluffing!”10

Will such threats be credible? The answer is yes insofar as any other pair of threats will be mutually irrational and each player will know this. Are they likely to be utilized? No. They are never to be played. Their role as in real life is to “orient” the game and provide a strong motivation for the players to reach a deal—a deal leaving everyone much better off than they are with the threat payoff. It is precisely when the players do not know the disagreement payoff that confusion results, cooperation breaks down, and threat strategies end up getting played. The advent of World War I offers a good example of such an outcome.

There is one last important point here. As Nash originally pointed out, the threats must be “enforceable” so that all players know for sure what happens if they do not reach a compromise and negotiations break down. They must be “binding.” For a good example of this logic, just recall the Doomsday machine of the Cold War. This machine represented the binding threat strategy that compelled compromise between the United States and Russia during the Cuban Missile Crisis. A very important point here is that, when the threats are credible and enforceable, neither player will have any reason to think that that opponent is bluffing when announcing his optimal threat.

The Meaning of Relative Power

The simplest way to think about the relative power between players in any bargaining game is to start off with the special “symmetrical” case in which all players will have equal relative power. This will occur if each and every player is strategically identical in terms of his resources, his preferences including his tolerance of risk, his contributions to all coalitions that might form, and his strategy sets—including his potential threat strategies as an individual, or a member of any coalition. If all players are strategically equal in this regard, their relative power is the same, and each ends up receiving an equal share of the pie at stake.

Differences in power will thus reflect differences in the strategic endowments of the players. Our fundamental result is: A player will have greater relative power than other players to the extent that:

1. He has greater resources than other players (money, military prowess, athletic prowess, intellectual capabilities).

2. He has greater threat power than other players as defined earlier.

3. He contributes more “worth” to the coalitions that he joins (e.g., an MVP has more power than other players because he contributes the most to his team).

4. He joins coalitions that are more powerful in opposing other coalitions than are the coalitions that other players join—that is, he has greater “coalitional muscle.”

5. He has greater tolerance for risk in pressing his demands than other players have, or equivalently, he has less “fear of ruin.”

Harsanyi formulated a power index measuring the relative power of different players in a manner that captures all five of these strategic dimensions of power.

Free Market Economics as a Special Case of n-Person Bargaining

The relationship between free market exchange theory and bargaining theory is remarkable, and this brief discussion of it will reinforce my thesis of the primacy of politics over economics. Market-based economic exchange can be analyzed as a very simple bartering game in which a consumer’s only threat strategy is not to buy an available product at the terms offered. “I want four cucumbers for my two squashes,” says one player. The counterparty shouts, “No way. I will only give you two cucumbers for those mealy squashes of yours.” They settle on an interim exchange rate of, say, three cucumbers for two squashes. Note that in bartering games of this kind, market prices do not exist and thus play no role.

Now consider a very special case of this bartering game in which (1) there are a very large number of players, (2) no individual player has any strategic power at all, and thus has no ability to create or to join any coalition of other players, (3) no player has any threat power at all against any other player except to decline a particular exchange offer, for example, “two squashes for two cucumbers is unacceptable, thank you,” and (4) prices do not exist to coordinate behavior.

When economic behavior is modeled in this manner, then the allocation of goods and services to every player that results from bartering will exactly coincide with the allocation awarded by a classical free market. In the latter case, a price system exists and coordinates who ends up with how much at a supply/demand equilibrium. The two different models are strategically equivalent in that every player takes home the same allocation of goods and services.

This was the celebrated result of the Israeli economist and Nobel laureate Robert Aumann cited earlier. It makes clear how “economics” in the sense of free market exchange with prices is a very limiting special case of the Nash-Harsanyi bargaining model of “politics.” The bargaining model will apply in any context, whatever the number of players, and whatever the setting, whether economic or political. Conversely, the market model will only apply in the extremely special circumstances of a perfectly competitive free market. In short, the bargaining model is the master model within which models of competitive economic markets only exist as special cases. So much for Economics Imperialism!

This concludes our summary of the Nash-Harsanyi theory. In my view, this offers the core model that should form the foundation of much political science. It rigorously addresses the fundamental question of who gets how much and why, along with subsidiary concepts like threats and power. What follows is a case study that demonstrates how applied bargaining theory can shed wholly new light on a very important issue: dealing with China.

An Application of the Bargaining Model to Today’s United States versus China Game: How Not to Negotiate with Thugocracies

As an American traveling the world, I find it ever more discouraging to witness the decline in the power and influence of the United States. On the economic front, it is now taken for granted that the Chinese economy will surpass that of the United States by around 2035, although estimates vary widely. But economic concerns about China far transcend the differential rates of growth. There is growing anger at China’s aggressive theft of intellectual property, the ongoing suppression of its exchange rate, and other long-standing mercantilist policies that continue to chafe.

In the longer term, there is the threat that China’s growing web of bilateral resource agreements with nations throughout the emerging world will subvert the concept of free markets in natural resources, thus putting the West at risk. For the better part of a century, the world has benefitted from free markets in most all resources, with aggregate supply and demand determining prices and allocations. Will this be replaced by a system of bidding for Chinese “allocation permits”—with permits primarily being granted to nations that play ball with China, a system almost certain to trigger a resource war? Anyone doubting this possibility should recall Russia’s behavior in cutting off natural gas supplies to the Ukraine when the latter’s government did not play ball with Putin, or recall China’s more recent threats of limiting “rare earth” exports to friends of the state. Both of these actions should serve as warning signs for the future.

China’s Growing Belligerence

On the political and military front, 2010 was the year when China came out of the closet and let it be known that it was gunning for various global spheres of influence. Not coincidentally, this was the year that the Obama administration canceled the U.S. F-22 as well as the space shuttle, and sharply introduced its reliance upon “cheaper” drone missiles. These moves signaled that the United States would follow in the footsteps of its European allies in devoting an ever-smaller share of its resources to defense, in exchange for an ever-greater share going to entitlements. Additionally, President Obama’s explicit forfeiture of U.S. leadership in the Libyan campaign offered additional proof of U.S. disengagement from global leadership.

The Chinese government had predicted much of this, of course, and is rapidly filling the growing power void with annual increases in military spending of an official 12.6 percent. A more believable estimate is probably around 14 percent. By introducing some reasonable assumptions, China could surpass the United States militarily within 25 years. Its excuse, of course, will be the need to protect its growing empire of overseas investments that will span the globe both east-to-west and north-to-south. China is a relatively resource-poor nation, and its government is understandably obsessed with its need for resources, given the size and the aspirations of its population.

The Chinese political and military expansion does not stop with its defense budget. There is growing truculence of every kind: its aggressive claims to the islands and underwater oil reserves throughout the Pacific Rim, its increasingly aggressive deployment of its navy, its plan to construct a naval base at Gawar on the coast of Pakistan, its ever-expanding claims to control over the South China Sea, and more. Nearly all of its neighbors are alarmed. Upset by the proposed Pakistani port, India is being drawn closer to the United States than it has been for years. The Vietnamese government is involved in an ongoing dispute over its claims to the Spratly and Paracel Islands. On June 22, 2011, China ordered the United States not to get involved in this dispute, typifying its new truculence. Vietnam for its part is so upset by bullying from China that it apparently has invited the U.S. navy to return to Cam Ranh Bay to protect it. Singapore, South Korea, Japan, the Philippines, and Taiwan are also increasingly concerned, and are speaking out.

Additional disturbing developments are taking place on the domestic political front. Increasingly, reformers in China are under attack as being “capitalist roaders” and next-generation Communist leaders are reviving Mao Zedongs’s musings, tactics, and memories. A disturbing internal power struggle is underway in this regard, with liberals losing out to conservatives. In a recent essay, General Liu Yuan, son of Mao’s earliest comrade-in-arms Liu Shaoqi, argues for a strengthening of the military over the cultural in China, praising war as the foundation of nation building, and expressing admiration for the 2001 terrorist attacks on the U.S. World Trade Center.

Others, fearful of future challenges to the Communist Party, are coalescing around Mao and his beliefs. Mr. Xiao in Hunan points out, “they seek the most powerful symbol of the Party, and Mao is the only thing that stands for that.” He argues that the members of the “princeling faction” take a dynastic view of political power, caring about ideology only to the extent that it can help them gain and maintain control. Current Chinese behavior certainly supports this appraisal.11

Must the United States Decline?

Does the reality that China is becoming an economic and military powerhouse seal the longer-term fate of the West, as is increasingly assumed? In particular, is it true that the United States is in rapid decline relative to China? Must it be? Is it as simple as extrapolating the contrasting growth rates of GDP and military spending, and then predicting China to be the victor? These forms of power cannot represent the whole story given the surprising successes in the past of such lesser entities as the Athenian republic, Macedonia under Alexander the Great, Portugal, Singapore, Hong Kong, and Holland. Each of these successes were unexpected in their time. Conversely, numerous big powers that by rights should have dominated lesser powers failed to do so throughout history. The Chinese empire between 1550 and 1980 arguably falls into this category.

In all cases, skill, determination, and leadership played a far greater role in establishing power than did size alone. But what in turn might such skill consist of? Is it ability to innovate? Here the West is at no ostensible disadvantage to the East, at least not yet. Is it superior productivity growth more generally? Certainly not in the case of the United States versus China, where available (if problematic) data suggest that the United States maintains its lead.12

Bargaining Skill

Is there some other advantage that plays an important role in the tug-of-war between the United States and China, and between the West and the East more generally? Yes, there is, and it is one that is virtually never cited: the ability of one side to outsmart the other in terms of its bargaining ability. I am now going to draw upon the Nash-Harsanyi theory to suggest that both the United States and its Western allies merit a grade of D in Bargaining Theory 101, whereas China merits an A. Of course, this suggestion is vacuous without understanding exactly what “bargaining ability” means. Intuitively, poor negotiators are those who fail to utilize their resources as effectively as they could, and vice versa for good negotiators. But all this is a bit vague, and I want to utilize the Nash-Harsanyi theory to clarify the deeper meaning of relative bargaining ability.

To begin with, the theory makes it possible to determine the outcome from bargaining that would be agreed upon by symmetrically rational players of equal skill. As a result, we have a concrete benchmark making it possible to rank players in any real-world game by their relative bargaining ability, and to do so in two different ways. First, a player who receives less than he ideally “should” according to the model will be said to be a less skilled bargainer, whereas one who gains more than he should is a more skilled bargainer. It is that simple. Second, and more subtly, if one player has more relative power than another in reality, then the real-world difference in their two degrees of power should conform to the Harsanyi power index described previously, assuming that both players have equal bargaining abilities. This is true because the Harsanyi power index is derived from and is consistent with the Nash-Harsanyi bargaining model that defines the outcome the underlying game. If their real-world difference in power differs from their Harsanyi power index scores, then a difference in bargaining skill must explain why.

We can thus identify differences in bargaining ability in either of two ways: First, we can compare the actual outcome of the game with the theoretically ideal outcome that parties of equal bargaining ability would arrive at. Second, we can assess the actual versus the theoretical amount of relative power of each party, and thus determine whether the actual power of one versus the other approximates what it ideally should be, or whether it differs. If it differs, the reason why will be different skills in bargaining.

In what follows, I shall pursue the second approach, and contrast the sources of relative power of China with those of the United States. The conclusion is that the United States has had far greater power than China has along most every dimension of relative power in recent decades, but has fared far worse than it should have in the deals it strikes. That is to say, the United States has bargained very poorly with China, and has repeatedly been taken advantage of to a degree inconsistent with the true power structure of the two nations.

Opportunity for the United States to Improve Its Bargaining Skills

This conclusion results from applying the deductive logic of the Nash-Harsanyi theory to the United States-China rivalry. The deductive nature of the theory with its emphasis on causality permits us to know why the United States and its allies have received less than a fair shake in their negotiations with Beijing. Armed with this understanding, the nation can in principle do a better job when bargaining in the future. The United States can learn how to bargain so that it achieves payoffs commensurate with its true power. In doing so, the United States and its allies should be able to slow down the relative decline of the West.

This message of hope for the West is altogether different from the more familiar message set forth by those who are banking on a Chinese implosion, much like that of post-1990 Japan. Their view stems from concerns about fraudulent Chinese statistics that overstate the nation’s growth and wealth, concerns about forthcoming Chinese resource shortages, worries about bad loans disguised on the balance sheets of dozens of regional banks, concerns about China’s own demographic crisis, anticipation of fighting between ethnic factions, and so forth. I shall not join this debate. For what it is worth, my own belief is that China will in fact emerge as the dominant economic power on earth because China possesses arguably the greatest asset on the planet: the attitude and ability of the Chinese worker. Nonetheless, its ascent will be slowed by its two principal flaws: a very poor legal system, and wide-scale corruption which is a corollary of a poor legal system.

The Determinants of Relative United States/Chinese Power

There are five different dimensions of power in the Nash-Harsanyi theory. I now attempt to show that the United States has been and remains more powerful than China along almost all of these dimensions, with the exception of perhaps the most important one: relative risk tolerance. Whereas China is highly risk tolerant (“determined”) in pressing for its agenda, the United States and its allies have become extremely risk averse, making threats that are vacuous, adopting supine policies, and rarely exacting a meaningful price from China for its egregious violations of international trade law. Since this risk aversion does not mirror the preferences and risk attitudes of most Americans, especially those millions who have lost their jobs to Chinese mercantilism, the behavior of the U.S. government can only be regarded as derelict. The relative risk aversion dimension of power will be discussed last. We will start off with the relative resource power of China and the United States.

1. Resource Power—Economic and Military

The United States has had, and still has, an overwhelming superiority over China as regards resources, although the gap has narrowed and will shrink at an accelerating rate over the next two decades. Let’s start off with economic resources of various kinds. No matter how it is measured, U.S. GDP is still far greater than Chinese GDP. This difference is far more pronounced when contrasting GDP per capita. Likewise, the net worth of the United States is estimated by the Federal Reserve Board to be $58 trillion whereas estimates of the net worth of China run from $15 to $25 trillion. In the latter case, however, no relevant data are published by Chinese economic authorities, so no one really knows China’s net worth. But this figure can be approximated since it is known that the net worth of a nation is usually 3.4 times its GDP; in China’s case, $5.87 trillion GDP times 3.4 = $20 trillion.

A nation’s debt burden represents a different dimension of resource power, but the logic is a bit trickier. Debt is a form of negative power to the extent that too much debt becomes a strategic encumbrance that can limit a nation’s options in the case of conflict. Thus, we increasingly hear that “the United States can no longer afford to intervene overseas and must focus on reducing its own deficit instead.” As for domestic debt, total federal debt in the United States is currently nearly 100 percent of GDP whereas the total debt of China is officially stated to be 20 percent of GDP, a very low number.

So at first glance, China has an edge over the United States in this regard. But as a Chinese government study published on June 27, 2011 demonstrated, the regional governments have additional debt equal to 27 percent of GDP. But this figure only includes debts that are explicitly guaranteed, and when provisions for bad loans by regional banks are added in, then total Chinese explicit debt is around 70 percent of GDP. But as Victor Shih of Northwestern University points out, “if you take a broad view of the Chinese government’s contingent liabilities rather than explicit debt on the books, then the number rises to well over 150 percent of GDP in 2010.”13

As for foreign debt—the debt owed by each nation to all other nations—the United States is in the doghouse, owing some $3.5 trillion more than it is owed. China on the contrary is the world’s largest net creditor nation. These imbalances pretty well amount to the sum of each nation’s trade balances over time. Thus, the total external debt of the United States is the sum of its past annual trade deficits with the world, and vice versa for China, which has run large global trade surpluses for a long time. In terms of bargaining power, external debt only matters as an encumbrance, just as was the case with domestic debt.

All in all, therefore, the economic resources of the United States currently give it considerable net power over China—for the moment. Yet looking forward, any such advantage will ebb away due to developments we have already cited. Not only will the GDP and net worth gap narrow and ultimately be reversed, but the United States debt status is almost certain to worsen, especially as regards domestic debt. The most serious risk for the United States lies in its tens of trillions of unfunded welfare benefits, especially medical benefits, as emphasized so starkly in Chapter 3. China will experience similar problems due to its own forthcoming demographic crisis, but it is taking a leaf from the West in not promising unrealistic entitlements benefits to its people.

As for military resource power, while the Chinese can boast of a huge standing army, their air and naval defenses are far inferior to those of the United States. These are the sources of military power that matter most in today’s world. All in all, the United States could prevail in almost any military engagement with China at the present time. But this U.S. advantage will ebb rapidly. There are two reasons why. First, China is determined to gain a first-class military capability, and it will have the financial and technological resources with which to do so. Second, the United States for its part has already begun to disarm because of existing fiscal demands. I fear an acceleration of U.S. disarmament as entitlements spending and rising interest expense on the debt soar in the decades ahead. The United States will join its European allies who decades ago disarmed so as to be able to finance cradle-to-grave security. Politicians can easily cut defense spending without losing votes, but they find it nearly impossible to cut unaffordable social benefits that never should have been promised in the first place.

The Obama administration’s cancellation of the development of the F-22 project is the most telling sign of what lies ahead, along with the dismantling of the U.S. space program. The F-22 decision guts the hope that the United States will maintain air superiority. Already, new Su-27 Chinese fighters will soon match our stealth bomber capability, and two such planes recently chased an American reconnaissance plane over the Taiwan Strait. The cost/benefit analysis used by the administration to justify its F-22 decision was badly flawed, apparently taking little account of the great benefit of maintaining absolute air superiority. Moreover, the cancellation of the F-22 was precisely the signal not to send to the Chinese at the very time they were becoming more belligerent on every front. To be sure, the F-22 program has had development problems. So did the stealth bomber for many years, but look at the results of persevering. The United States has remained unassailable for decades due to its superior air power.

2. Threat Power

For purposes of judging the outcome of the United States-China rivalry to date, this is perhaps the most interesting and also misunderstood of the five dimensions of power. Therefore I devote considerable time to threat power, both military and economic. Remember in what follows that what matters in assessing threat power is not how much damage a player can do to his opponent, but rather how much damage a player can do net the cost to himself of doing so.

Military Threat Power

With its extensive short- and long-range missile capabilities, and its air and naval cover, the United States could inflict terrible damage on China at virtually no cost to itself, whereas the reverse holds true for China. The United States thus has and has had far greater military threat power than China. But for reasons just stated, this differential will shrink rapidly. The one area where China may already have a relative advantage over the United States is in cyber-espionage. The 2007 incursion into the office of Secretary of Defense Robert Gates and more recently into Google and Morgan Stanley are highly disturbing. The possibilities here are truly frightening, as cyber-espionage can easily morph into cyber-warfare.

To date, neither the United States nor China has had to issue threats and flex its military muscles against one another. There has been no source of military conflict between the two powers save for ongoing saber-rattling over Taiwan. This will no longer be the case in the future were China to deny the United States (or her allies) access to markets for those global resources in emerging markets it increasingly tends to control. This would be a new form of threat power that is quite probable looking forward.

To begin with, China’s weak spot is its lack of resources. To cope with this, the nation is developing a global supply chain that is requiring huge investments of manpower and capital across the globe. The great question lurking here is: Will these resources be added to what we normally think of as “global supply” that can be “globally demanded” by any buyer willing to meet the market price? Or will the supply be preempted for Chinese consumption via long-term contracts negotiated bilaterally between China and its investment partners? In the latter case, the threat of resource wars will loom large. The failure of the United States and its allies to develop their own supply of future resources all but ensures that resource wars will occur.

A good example of the failure of the United States to act in its own interest in this regard has been the abject performance of the U.S. Department of Energy. A Harvard Business School case study should be written about the money that has been wasted on this bureaucracy. Its ineptitude and inaction has made the all-important concept of “U.S. energy independence” a joke around the world. President Obama’s State of the Union address in January 2011 risibly equated energy independence with the production of more solar panels. The point was not lost on anyone.

The truth is that, with proper leadership and appropriate supply-side policies, the United States could easily be gaining energy independence from those thugocracies on whom we now depend. In doing so, the United States would not only achieve energy independence, but by reducing its trade deficit, would boost GDP as well. Most important, its threat power would increase since energy producers like Iran and Venezuela could no longer threaten to cut off their supplies. By stymieing energy independence at every turn, the Obama administration is reducing the nation’s future threat power. This may well leave U.S. military action in the form of resource blockades as the only viable option for gaining increased resource supply from overseas in future decades.

Economic Threat Power

The area of trade is where the differential threat power of the two nations has been most important to date. Up to five years ago, it would perhaps have been necessary to defend the view that China has to a very significant degree cheated its way to its balance-of-trade hegemony via decades of hypermercantilist policies—policies never effectively opposed by those impacted in the West. These policies included currency-rigging in the extreme, violation of any number of covenants intended to foster free and fair trade, outright theft of intellectual property worth hundreds of billions of dollars, the large-scale production of counterfeit goods, and so on. But within the past few years, most observers have conceded that China has gotten away with murder in its trade relations, and that something has to be done about it. Please bear with me here, as several of the issues that arise are inherently counterintuitive, and thus widely misunderstood.

A very interesting “big picture” article on this subject was written in 2004 by the late Paul Samuelson of MIT, America’s first Nobel Laureate in economics.14 In a phone conversation I had with Professor Samuelson just after he published this essay, he told me that proving the case of currency manipulation by China was the easy part of the story. The more important part was that China’s behavior had undermined the entire basis of free trade, namely the Ricardian principle of advantage, by means of its unprecedented policy of intellectual property theft.

Intellectual Property Theft

Suppose Country A has an advantage over country B in producing, say, maple syrup, because Country A was endowed with maple forests whereas country B was not. And vice versa in the case of whatever natural endowment country B possesses that Country A does not. As a result, it is in both nations’ interest that they trade. Samuelson commented that China had changed the rules of this game for the worse by demanding that, in order for country A to sell its maple syrup to China, it would have to export its forest of maple trees as well. Otherwise, there is no deal.

I have often been infuriated to read that Intel or some other such company can only manufacture inside China if it hands over a large number of what used to be known as “trade secrets,” that is, the very basis of the competitive advantage U.S. companies achieved by decades of hard work and innovation. I have been ever more infuriated by the supine response of the U.S. Department of Commerce and other agencies in almost never exacting a price from China for its transgressions. All we seem able to do is to protest, ineffectually. We rarely if ever retaliate and give China some of her own medicine despite the reality that we possess much more relative threat power than it does, as will be seen later in this chapter.

Currency Manipulation Proper

Bad as China’s policy of intellectual property theft may have been, it is still important to understand the magnitude of Chinese currency market manipulation in recent decades, and its true impact. For this is the arena in which the issue of threat power has arisen most dramatically, and in which the West has abjectly failed to utilize the threat power advantage it had. The result was lower GDP growth, an excessive loss of jobs, and decreased wealth. What is important is to contrast what “should” have happened to the yuan/dollar according to the theory of free and fair trade, versus what did happen.

Broadly speaking, when a newcomer to the world economy soars from rags to riches as China has since 1980, its currency will and should appreciate very significantly relative to the currencies of stodgier, older economies. This statement assumes free and fair trade of the kind endorsed by the covenants of the World Trade Organization. Figure 5.1 makes clear what actually happened in this regard. I have also included the behavior of the Japanese yen for purposes of comparison.

Figure 5.1 The Dirty Little Secret about the Chinese Yuan

Source: Bloomberg, and Strategic Economic Decisions, Inc.

The astonishing fact that the Chinese yuan relative to the dollar was repeatedly devalued—not revalued upward—is a dirty little secret known to very few. I will never know why. Perhaps this results from living in an era of foreshortened memories, where databases typically go back only five or ten years. We regularly hear about China’s willingness “finally” to let the yuan appreciate by some 27 percent between 2005 and today. But what actually matters is that, even after this act of generosity by the Chinese government, their currency is worth well under half what it was worth when the Chinese economy was in shambles as late as the early 1980s. And between 1990 and 2011, the yuan/dollar has depreciated by 46 percent. Depreciated! It is hard to believe that this could have happened, much less that no one ever mentions it. Please study the figure.

Part of the explanation for this devaluation concerns what happened in the mid-1990s. China’s currency policy before 1994 must be viewed differently from the period after 1994 because, prior to 1994, the yuan traded at two different exchange rates: an official and an unofficial rate (the latter for preferred customers). In 1994, these were aligned via a devaluation, as seen in the figure. What is remarkable is that, having devalued the official rate significantly via the alignment, the currency never appreciated thereafter until late 2005, and very slowly after that, always remaining far lower than its earlier pre-1994 value. The explanation for this outcome was full-scale currency manipulation as many scholars have noted.

To grasp the true magnitude of what happened, contrast the case of China with that of Japan as shown in the figure. To begin with, Japan’s rise during 1970 to 1990 was much less spectacular than China’s more recent rise, partly because Japan was already a wealthy economy. Theoretically, this predicts that the rise of the yen should have been much less than that of the yuan. To be sure, Japan fought fiercely for its cheap (devalued) yen throughout the 1970s and 1980s, but the United States and her allies strongly jawboned the nation to let its currency appreciate, which it did. The yen more than doubled against the dollar as the figure makes clear. Nothing comparable was done to force China to revalue as successive U.S. administrations let China get its way, and failed to make any credible threats against it.

Two Reasons Why the Yuan Should Have Appreciated

In the context of free and fair trade, how exactly does economic theory predict that the currency of a winner like China will appreciate hugely? There are two reasons, both rarely cited. First, consider a simplistic model in which trade in goods and services is the only kind of trade permitted. Trade in assets is forbidden. Then in this case, there can be no trade deficits at all since such deficits are financed by asset sales. Accordingly, the currency value must change so as to keep the trade deficit at zero. A rising star like China would find that, with its newfound productivity and cheap labor, the United States (and other established nations) starts to buy far more Chinese goods than China wants to buy U.S. goods. The result: The demand by Americans (and others) for the yuan with which to buy Chinese goods will far exceed the demand by China for dollars with which to acquire U.S. goods. As a result, the Chinese currency must appreciate by the law of supply and demand, and by a lot over time. The higher yuan permits the trade deficit to remain at zero, as required, because a stronger yuan encourages the Chinese to buy more foreign goods, and it discourages foreigners from buying Chinese goods.

Matters become more complicated when we extend this simple model to include trade in assets, whether in real estate, T-bills, or whatever. The main story here, known as the Belassa-Samuelson effect, is that trade in assets should cause a further appreciation of the currency of the emerging economy. Why is this the case? Assuming that China enjoys the rule of law and transparent investment policies, foreigners will want to invest in rapidly appreciating Chinese assets far more than the Chinese will want to buy the assets of slower-growing, more established nations. This translates into greater demand by foreigners for the yuan than Chinese demand for dollars (or whatever), since foreigners must acquire yuan to invest in China, and the Chinese must acquire dollars to invest in the States. As a result, the Chinese currency is pushed up yet again by the simple law of supply and demand.

By taking both of these stories into account, a case can be made that between 1980 and 2010, the Chinese currency could well have appreciated by some 300 percent, if not even more, had China let the currency market function freely. But due to an astonishing level of open market purchases of dollars, accumulating over $3 trillion in foreign exchange reserves, by keeping its capital account closed, by permitting corrupt judicial and administrative practices to frighten away foreign investors like myself, and by endorsing a raft of other unfair policies, including the sale of counterfeit goods and intellectual property theft, the Chinese currency is valued at roughly half of what is was some 20 years ago. That is an exchange rate of one-sixth of what it arguably should be.

Certain academic economists sympathetic to China make the case that we should ignore the United States/Chinese trade imbalance and by extension the yuan/dollar exchange rate, and focus instead on China’s trade balance with the entire rest of the world, a balance that has shrunk. This is very unconvincing. Exchange rates are binary by nature, and these binary rates matter. After all, they constitute prices of a very important kind. The United States was China’s primary target market for exports for two decades. What Figure 5.1 makes crystal clear is that, while we should have experienced a soaring yuan, and accordingly a much lesser outsourcing of jobs than we did, the United States experienced the reverse to its great detriment, while becoming the world’s largest net debtor in the process.

Failure to Utilize Our Relative Threat Power Superiority—A Political Disgrace

The supine response of the United States to China in matters of trade would have been understandable had China had a significant threat power advantage over the United States. But it did not, as a Nash-Harsanyi analysis of optimal threats makes crystal clear. To begin with, the Chinese government has depended hugely on its ability to export manufactured goods to the West. During the past two decades, it understandably felt obliged to create hundreds of millions of new jobs to prevent unrest, if not outright revolution, and China’s leaders have acknowledged this throughout the past two decades. Had the United States (in conjunction with other Western powers) said “enough” and issued an enforceable threat of large import tariffs unless they played fair, it would have hurt the Chinese gravely. But what would have been the offsetting cost to us of doing so?

The standard reply is that Americans would have suffered for two reasons. First, the government would to some extent have denied U.S. workers some of those extra-cheap Chinese imports that have raised U.S. living standards. To be sure, many consumers did benefit, but consumer well-being is not the appropriate measure of what is good for the nation as a whole. Don’t millions of lost jobs enter into this calculus? And what about growing indebtedness to foreigners due to financing huge trade deficits? Second, the U.S. inflation rate would have been driven higher. This could have happened, to a limited extent. But the econometric evidence shows that the link between trade and the inflation rate has become very tenuous during the past two decades.

Remember that, to assess relative threat power, we must assess the situation when viewed from China’s perspective as well as from our own. Had the United States played tough, what could China have done in retaliation? What was its threat power? It had virtually none. Of course, they could have refused to export their “cheap goods” to us, but doing so would have hurt them far more than us, as just explained. Additionally, they could have stopped funding the U.S. trade deficit by cutting back on purchases of U.S. Treasuries, as they recently have. U.S. interest rates then get driven up, damaging the domestic economy. This, at least, is their standard threat, but it is vacuous. As will be explained, the U.S. deficit will get funded regardless of the size of Chinese purchases of Treasuries. All China would end up achieving by not buying U.S. Treasuries is a lower value of the dollar, not higher U.S. interest rates. But a lower dollar is good for the U.S. economy, and arguably bad for China.

To sum up, the Chinese had a fraction of the relative threat power that the United States possessed during the two-decade-long period when we continually rolled over and gave them everything they wanted. From a Nash-Harsanyi standpoint, this represented extreme bargaining incompetence on the part of five successive U.S. administrations. There is a lesson in all this for how differently the United States should act in future confrontations with China.

What the United States and Its Allies Should Have Done a Decade Ago

The United States and its allies should have made China’s admission to the World Trade Organization in 2001 conditional upon abandoning their hyper-mercantilist policies. The Chinese would have been told five years in advance that their admission was dependent upon opening their capital account and permitting the yuan to appreciate, upon ceasing to steal intellectual property rights, upon ceasing to sell counterfeit goods (e.g., fake Gucci bags), and so forth. The price to them of not doing so would be not only rejection from the WTO, but also stiff punitive tariffs enacted by all the major Western allies. The reason for advance notice is important. In bargaining theory, you should never back a player into a corner. This could have been avoided by articulating credible and enforceable penalties that China would incur in the future by failing to adhere to globally accepted concepts of free and fair trade. China would then have had the time required to make suitable adjustments.

But what did we do? The United States acted as if China possessed the threat power, whereas we did not. Our government sold our own population’s interests right down the drain. The United States also failed to create a coalition of other nations such that China would have had no alternative but to play ball. Instead no coalition was organized, and the Chinese government pursued a divide-and-conquer strategy, isolating potential Western allies from each other. They gained WTO admission on their own terms, and that was that. How dare our policy makers have let this happen, perpetually apologizing for China, and exhorting domestic manufacturers to be patient and accommodate China’s “period of reentry” into the global economy? Exactly whose interests should our representatives in Washington have been defending?

Four Fallacies about Relations with China

First, it is easy to misinterpret the gist of my main argument, and to conclude that it is anti-Chinese in spirit. It is not. I have no objection to the rise of a great trading partner whose success causes an ongoing outsourcing of jobs here at home. Everyone should welcome the return of China to the world fold. What I and many other observers are concerned about is the excessive rate of U.S. job losses, of GDP loss, and of foreign indebtedness growth that excessive Chinese mercantilism has brought about. I know of no definitive analysis of the difference between the number of good jobs that United States and Europe have lost versus the lesser number we should have lost had China played fair and square, and let the yuan appreciate significantly rather than fall nearly half in value. But estimates in the range of 5 to 7 million jobs are often floated.

In a 2010 Briefing Paper of the Economic Policy Institute,15 Robert Scott examines extensive evidence on the subject of job losses to China, and concludes that the United States alone lost 2.4 million jobs since 2001. Add in losses during the 1990s, and losses suffered by other nations, and this total of over 5 million seems reasonable. Also, Scott’s numbers do not apparently include job losses from exports to China that would have materialized were it not for China’s currency policy, and its other forms of mercantilism.

The second fallacy concerns those alleged benefits to United States and other Western consumers that cheap Chinese imports made possible. As indicated previously, this is at best a half-truth. Let’s tally up the costs of these alleged benefits. To begin with, some economists claim that the cheap yuan encouraged the excess consumption that has imbalanced and damaged the U.S. economy during the past two decades. Additionally, those ever-so-cheap Chinese goods that we consumed caused a ballooning trade deficit. By elementary economic theory, such deficits result in growing indebtedness to foreigners (debt that must be serviced, thereby reducing future living standards), reduced levels of GDP growth, and increased unemployment due to excessive outsourcing. So all in all, there was nothing “free” at all in the cheapness of these goods. As we all learn in Econ 101, there really is no free lunch in economics.

The third fallacy centers on the oft-cited claim that the Chinese could drive up our interest rates by not funding our fiscal deficit. This is the single most widespread fallacy that I know of in international economics. It involves what is known as “the adjustment process” whereby, when a surplus nation (China) ceases to buy the assets (T-bills) of a debtor nation (the United States), then either the dollar falls, or the interest rate rises, or both. Over 90 percent of the time, it turns out that the dollar falls and the interest rate does not get driven up. This fact can be substantiated both in the data, and at a theoretical level. If the interest rate is not driven up, but the dollar falls as usually happens, then Main Street U.S.A. will benefit. Its factories will export more, and its hotels will be full. Moreover, since China pegs its currency to the value of the dollar, should China drive down the dollar and thus the yuan with it, the rest of the world would be even more irate with China’s currency policy than it already is. In sum, China has virtually no threat power over the United States in this regard. What about the ancillary threat that U.S. deficit would no longer be “funded”? It turns out that that, too, is a concept with no meaning, and it cannot happen for reasons explained in endnote 16.16

The fourth and last fallacy concerns the misplaced belief that any retaliation against China’s currency policy would somehow have been “protectionist” and thus wrong on our part. But as Paul Samuelson has stressed, there is nothing protectionist in retaliating against protectionism already initiated by another nation. The concept of “free and fair trade” is a symmetrical relationship between nations. More specifically, the benefits from free trade presuppose that all parties play by the rules of the game—not all parties except for a few that choose not to for their own benefit. In the latter instance, those who cheat can and should be made to pay a stiff price until they either agree to play ball, or are tossed out of the fold with much reduced access to global markets.

Economic Threat Power in the Future

Looking forward, the position of the United States has been badly damaged by letting China get away with its mercantilist agenda. We have transferred (or permitted to be stolen) priceless intellectual property rights, become a huge net debtor, and permitted China illegitimately to become dominant in many markets. Regaining lost share in these markets would be very difficult. Additionally, as time has gone by, supply chains have become linked in such a way that punitive tariffs would not only hurt China, but also the economies of the West.

3. United States versus China—Coalitional Worth

This is the simplest dimension of relative power to analyze in a United States-versus-China context. It addresses the relative value a player contributes to such coalitions as he joins. The United States is the richest, most productive, and most powerful nation on earth. The worth it brings to any coalition of other nations is greater than the value that China can bring to any coalition it might join, with rare exceptions. But the gap here will shrink as China becomes bigger and more powerful, develops its own middle class, and permits consumption spending to rise from 35 percent of GDP today to over 50 percent, as it ultimately will.

As this happens, China can offer ever more benefits to any coalitions it might join, in particular preferential access to its own growing markets. But for the moment, the United States is MVP to team Earth. This reality is strengthened by the belief that the United States is a reliable and reasonably benevolent partner, as well as one endowed with a high-quality legal system. China lacks both of these attributes.

For all this, there is one area in which China possesses growing coalitional worth that outstrips that of the United States and almost every other nation. This is its willingness and ability to invest in the economic development of problematic emerging economies, economies that most Western nations may wish to steer clear of. China overlooks those issues of corruption, poor environmental standards, and human rights violations that may trouble most other investors. China asks no questions, takes control, and consents to build turnkey plants, projects, and even cities—largely on its own terms and often with its own labor. In such circumstances, China can emerge as a more valuable partner to the host countries involved than the United States and its allies can. Its coalitional worth is higher.

Regrettably, while China often disguises such investments as economic in nature, they are becoming increasingly political and disruptive. Nowhere is this clearer than in its growing involvement with Pakistan. “The pattern of trade and investment between China and Pakistan suggests that the United States has little chance of retaining its status as Pakistan’s major ally,” suggests James Brazier, an analyst at HIS, a U.S.-based political risk consultancy. He goes on: “Pakistan’s relationship with China could soon resemble that of Myanmar (Burma), another former part of British India which is now closely dependent upon China.”17 Increasingly, Pakistan’s feared ISI intelligence agency has closer ties with its Chinese counterparts than it does with the U.S. CIA. In India, New Delhi’s politicians and military command frequently voice their concerns about the nature of China’s assistance to Pakistan. They point to the port at Gwadar on the Arabian Sea built by the Chinese Harbour Engineering Company, to dams built on sensitive sites, and to the sale of sophisticated military hardware including jet fighters, helicopters, frigates, and “civilian” nuclear assistance.

4. Coalitional Power

Coalitional power will reflect the relative strengths of the coalitions that the United States and China respectively are apt to join, or to create. Here the United States would seem to hold the upper hand for two reasons. First, for reasons of history, the United States has succeeded in forming any number of fruitful alliances with powerful nations during the past century. Coalitions that have included the United States as a member, like NATO, have had lots of muscle. Additionally, the United States befriended its former enemy Japan immediately after Japan’s surrender in 1945 at the end of World War II. The resulting United States–Japanese alliance ruled the Pacific theater for many decades thereafter. Finally, there was the Marshall Plan in Europe which is universally considered to have been a benevolent and successful venture by the United States.

China’s situation is quite different. In recent years, it has largely kept to itself, and has not forged alliances with powerful nations, with the possible exception of Russia. Nor has it needed to, given the nature of its ambitions. However, now that the nation is becoming rich and powerful, is maturing, and is flexing its military and political muscles, it may well seek to form coalitions. However, it would seem as if it is more interested in two-party partnerships based upon reciprocal economic needs than it is in multiparty political coalitions. Even then, China’s “partners” inevitably express concern about the hard terms China drives in its bargains, and in particular the degree of control it seeks. Pakistan’s explicit concerns cited earlier offer a good case in point at present. All in all, the United States should continue to possess greater coalitional power than China.

5. Relative Risk Tolerance—The Big Story

This determinant of power along with relative threat power is the most important variable for assessing relative power in the United States versus China bargaining game. As mentioned previously, the Nash-Harsanyi theory establishes that the players’ relative risk attitudes are very important in determining which player gets how much of the pie at stake. With equal risk tolerances, the pie gets divided 50/50, abstracting from issues of threats and coalitional muscle. The greater the risk aversion of one player relative to that of the other, the lesser his share of the pie as the result of bargaining.

When this logic is applied to the United States versus China bargaining game, the conclusion we arrive at is very disturbing. What we have just seen is that, in four of the five other determinants of relative power, the United States has greater power than China. This was particularly true in the case of relative threat power in matters of economics and trade. But if this is true, why has China virtually always prevailed over the United States during the past three decades, and why did the United States never retaliate in an effective manner? There are only two possible explanations. If you assume that the United States behaved rationally in the sense of bargaining theory, then the only reason it buckled was because of extreme risk aversion. We simply would not risk rocking the boat, and we did not do so. The decision was always to roll over and “give the Chinese more time.” The Chinese, on the other hand, were relentless in pressing their agenda, and they prevailed, especially as regards their currency value and their trade practices. They were willing to assume large risks. They felt that they needed to win, and they did.

Assuming that extreme risk aversion on the part of successive U.S. State Departments and administrations was the reason for the outcome of the bargaining game, a subsidiary question arises: What entitled our elected representatives to sell the United States down the drain, along with millions of outsourced jobs? Did they assume that the citizens they represented were themselves completely risk averse, and that we did not mind losing millions of good jobs and becoming a huge net debtor nation? I don’t recall being polled as to my views on this subject. Nor to be sure does anyone else.

Additionally, where were the media, and economic commentators for that matter? Until recently, most assumed the risk-averse position of the New York Times. In commenting on punitive Congressional legislation proposed in early 2007, a lead Times editorial of August 13, 2007 stated: “We have consistently argued against such punitive legislation, which could harm America’s economy by unleashing a trade war.” In his essay cited earlier in the chapter, the late Paul Samuelson exposed the fallacy of this view. It is only when free and fair trade exists across all nations that no one player should adopt punitive measures and thereby risk a trade war. But in the real world, China never played free and fair, so the United States and all other nations had every right to defend themselves via retaliation at any point they might have chosen. They chose not to do so.

Now assume that the U.S. government was not in fact very risk averse. What then could explain the weak position it assumed in conflict after conflict with China, keeping in mind that the United States was much more powerful than China? The only remaining explanation would be an abject lack of bargaining ability. In my opinion, this lack of skill partly stems from a widespread misconception about the role of threats in bargaining. It seems to be very politically incorrect for the U.S. State Department to make credible threats. Instead of making credible threats, it expresses “concern,” whatever good that does. “But couldn’t making threats lead to war?” is a constant refrain from self-styled doves. The answer, in fact, is no. This is a central point of the Nash-Harsanyi theory that very few people grasp: When threats are made that are optimal and credible in the sense I have explained, they rarely ever get played. A cooperative agreement is reached, largely induced by the articulation of credible threats. Today’s mantra of “being diplomatic” and not rocking the boat may have it all backward. The ancients were right when they said, “If you wish for peace, prepare for war.”

The net result of this case study is that the United States enjoyed much greater power than China along every dimension of power except for relative risk aversion. Yet it buckled in most every confrontation with China, at least in matters of trade policy. The United States thus receives a D in Bargaining 101, whereas China receives an A. The foregoing case study can perhaps be criticized for being too retrospective, and not focusing enough on the future. But this is not primarily a chapter on bargaining with China in the years ahead. My main goal has been to use a real-world case study drawn from the past to showcase how the imperatives of bargaining theory can help us avoid the kinds of mistakes we have made in the past, and thereby do a better job in the future.

Looking forward, the principal economic imperative is that the United States should form Fair Trade coalitions with its Western allies, and utilize its coalitional power to force China to redress its unfair practices under penalty of large tariffs, should it fail to do so. Any such threat strategy must be credible and binding, and should give China time to adjust. On the military front, the United States should forge Free Passage coalitions with Vietnam, India, Brunei, Malaysia, Singapore, the Philippines, and other nations now being threatened by China in international waterways, especially the South China Sea and the Indian Ocean. In late July of 2011, a Chinese warship confronted an Indian navy vessel shortly after it left Vietnamese waters. The Chinese warship demanded that India’s INS Airavat identify itself and explain its presence in international waters shortly after it completed a scheduled port call in Vietnam.

China’s blatant disregard for international law and the right of free passage in international waterways reflects its determination to seize de facto control of the entire South China Sea, and to intimidate free passage in the Indian Ocean as well. New Delhi is understandably up in arms at these bully tactics, but this is what we can expect from China unless it is properly checked by appropriate superpower action. The United States in particular should guarantee free passage to any legitimate voyage. Further appeasement of China will lead only to worse confrontation later, as both history and game theory predict.

The Remarkable Power of the Bargaining Model in Political Science and Beyond

Having completed the case study of the United States-versus-China bargaining game, let me conclude this chapter by summarizing six different ways in which the Nash-Harsanyi model of politics represents a powerful platform for a reconstruction of political science.

1. Incorporating the Right Mix of Cooperative and Noncooperative Game Theory

In searching for the right paradigm with which to make sense of strategic interaction, game theorists during the past six decades believed that they needed to choose between two very different kinds of games: noncooperative versus cooperative games. In the former case, every player individually and in isolation adopts a strategy that is optimal against every other player’s strategy. This requirement must hold true in a binary manner for all pairs of players. Coalitions of players advancing their common interests do not exist in noncooperative games. No threats or binding agreements can be made. No cooperation is possible between people. Bargaining as we think of it does not exist. It is all unrealistically atomistic.

Nonetheless, the noncooperative game can be very useful in special circumstances. The most celebrated example is the Prisoner’s Dilemma game, a noncooperative game that is studied in virtually all branches of the social sciences. Two prisoners are kept in isolation from each other. Since neither prisoner can get together with the other and make a binding agreement not to tattle on the other, no gains from cooperation are possible. In this case, the noncooperative solution of the game is for each prisoner in isolation to tattle on the other in hopes of receiving a shorter prison term. The result: Both tattle, and both serve a longer term than they would have served had they been able to communicate and agree not to tattle on each other.

Interesting as this example may be, most real world games are not like the Prisoner’s Dilemma. People are not isolated. They cooperate and make binding agreements to advance their mutual interests. Nonetheless, the noncooperative perspective has dominated game theory for the past few decades. Previously, the cooperative paradigm had been dominant. In this latter case, players enter cooperatively into coalitions for the purposes of adopting coordinated strategies that end up leaving all members better off. In other words, bargaining takes place. Threats can be made. Cooperation is central. Yet a problem with many classical cooperative game models was that they could not properly incorporate the role of optimal threats as a prelude to a “final settlement” in bargaining, nor accommodate players’ different intensities of preference for the stakes in the game.

The first great virtue of the Nash-Harsanyi theory is that it overcame both these limitations, and emerged as the most persuasive of all cooperative game theories. Its second virtue was that it integrated the paradigms of both cooperative and noncooperative theory into a single integrated theory, one that could be deduced from very fundamental axioms. Noncooperative behavior is captured in the stage 1 threat game (“If I don’t get my way, I’ll see that you pay dearly”), whereas cooperative behavior is captured in the stage 2 game (“Let’s all end up better off and split the gains from cooperation fairly”). In the process of integrating these two perspectives, these game theorists also showed how the stage 1 and stage 2 games are logically interdependent: One cannot be solved without solving the other.18

2. Ridding Political Science and Economics of the Anthropomorphic Fallacy

Throughout much of political and social science, it has been implicitly assumed that groups of diverse people with divergent and competing goals can be analyzed as if they were a single person. Political analysts were traditionally forced to adopt the anthropomorphic conceit that society could be modeled as a single group, namely “the people” or “the public.” The preferences of diverse people could be represented by the “social preferences” of the group. In economics, the concept of a “representative consumer” was introduced to represent a host of individual consumers of differing tastes. But as would eventually be realized in both disciplines, such aggregations of individuals into a fictitious group called “society” possessing “social preferences” are almost always logically illegitimate, and cannot be made without paradoxical implications.19

In the Nash-Harsanyi model, and in many other game theoretic models, there is no need to carry out such aggregations. The anthropomorphic fallacy is dispensed with at the outset. When policies are adopted, nothing is being “maximized.” The concept central to economics of a person attempting to maximize his utility by selecting the best mix of foods for dinner or the best mix of assets for a portfolio is replaced by a radically different concept: The achievement of an optimal compromise between individuals and groups with different goals. This tectonic shift was of such importance that the great “Johnny” von Neumann who originally created and mathematized game theory in the 1940s would regularly boast that, in game theory, nothing is being maximized. He contrasted this with the case of physics, in which almost every law can be stated as the solution to a particular maximization/minimization problem. He viewed this as a great advance in science, which indeed it was.

3. Highlighting Why Credible Threats Are Required for Peace

The bargaining model highlights a very important insight for public policy analysis: If policy makers in different nations really want peace (the cooperative solution), they must articulate very clearly exactly what will happen should the cooperative solution not be reached, and should they have to fall back and play their optimal threat strategies. If they do not do so, and are confused about what will happen if negotiations break down, the result can be needless misunderstandings leading to, say, war. As we stressed earlier, threats must be crystal clear, credible, and enforceable. Contrast this theoretical requirement with today’s soft-power environment in which it is politically incorrect in the extreme even to mention the word threat, much less the term “binding and enforceable threat.”

The point I am making is not theoretical at all. The role of explicit, binding threats was critical in the development of the doctrine of mutual assured destruction (MAD) that governed the balance of terror during the Cold War with the Soviet Union. The concessions made by the Russian government that prevented war when it backed down during the Cuban Missile Crisis would not have been made had Russia not understood that thermonuclear annihilation would have been the result of not compromising.

4. Providing a Yardstick for Measuring Bargaining Ability and Political Competence in General

In the absence of a compelling definition of a rational bargaining outcome, it is difficult to say whether a given party bargained competently or incompetently during its negotiations with others. By extension, with no yardstick in hand, there can be little accountability by government to its citizens regarding the quality of the bargains it strikes on their behalf. Happily, the Nash-Harsanyi model provides precisely the missing yardstick, as was hopefully clear in our analysis of the United States/China game.

5. Offering a Simple, Graphic Representation of Politics

Political science will never be a “science,” much less a successor to economics as the dominant paradigm without some intuitively appealing core model that can be summarized by a couple of intuitively appealing graphs. In economics, that model is the concept of “market equilibrium” graphed by intersecting supply and demand curves. The Nash-Harsanyi theory can and should play an identical role within political science, and it, too, can be summarized graphically. It is outside the scope of this book to exhibit this here, but I hope you will take it on faith that an intuitively appealing pair of graphs exist that could render a new concept of political science as intuitively appealing as supply = demand is in economics.20

6. Offering a Unifying Framework for the Moral Tripos of Politics, Economics, and Philosophy

There is one last way in which the Nash-Harsanyi theory is remarkable. It can be shown to unify at a very deep level the fields of Moral Philosophy, Economics, and Political Science. More specifically, consider such disparate topics as the theory of fair representation in political philosophy, the question of how to allocate the “pie” in proportion to the relative contribution made by those baking the pie, the problem of allocating pie in proportion to people’s needs, the issue of measuring different people’s relative power in a conflict situation, the problem of assessing people’s relative social status, the concept of a political balance of power (multilateral bargaining equilibrium) as previously discussed and finally the concept of a supply/demand market equilibrium in classical economics.

It turns out that the equations of the Nash-Harsanyi theory can be restated in many different ways, yielding appealing solutions to the central problems of all seven of these topics. You have already learned about one of these results, namely Robert Aumann’s discovery that a competitive market economy corresponds exactly to a degenerate bargaining game in which no agents have any power with which to form coalitions. Back in 1978, I proposed that a formal unification of multiple disciplines would one day be possible, assuming that certain theoretical problems were solved first.21

These problems have now been solved, and I hope to demonstrate a complete unification of the Moral Tripos of Economics, Politics, and Philosophy in a future book. In the next and final chapter, I will sketch a second example of the proposed unification: how deep-rooted problems in the subject of distributive justice can be solved using a bargaining theoretic framework.

1. Two other scholars also played an important role in developing a theory closely allied to the Nash-Harsanyi theory of bargaining: Lloyd Shapley of UCLA and Reinhard Selten of the University of Bonn. But their initial focus was more upon the axiomatic valuation theory of cooperative games than on bargaining theory per se.

2. As regards economics being a special limiting case of politics, the basic result here was proved in 1977 by the mathematician Robert J. Aumann of Hebrew University, one of several contributions that would earn him the Nobel Memorial Prize in Economic Sciences. [Technically, he did not utilize the actual Nash-Harsanyi theory but a “linearized” version of it known at the non-transferable utility (NTU)- value of a game.] Seen in this light, bargaining theory emerges as the master discipline subsuming both politics and, as a very special case, free market economics. This is the perspective I shall adopt throughout this discussion. I have never seen this viewpoint expressed within the political science community, especially amongst rational choice theorists. Indeed, I do not believe Aumann’s contribution is either known or understood in that community which is unfortunate since his result puts matters into a new and important perspective. See Robert J. Aumann, “Values of Economies with a Continuum of Traders,” Econometrica 43 (1975), 611–646.

3. Theoretical political scientists of the “rational choice” school may be quite unhappy with what I am writing here, so let me defend my argument. To be sure, rational choice models drawn largely from economics have made a grand foray into many branches of political science in recent decades. This began with the revolution within social choice theory inaugurated by Kenneth Arrow’s celebrated impossibility theorem of 1950, and the subsequent rise of Public Choice theory. It proliferated from there in many directions. My problem lies with the kind of rational-choice models chosen, and in the inability of these models to achieve the insights into bargaining proper that the Nash-Harsanyi model alone permits. To explain this view, I must utilize a bit of academic jargon. The fundamental difference between the Nash-Harsanyi approach and that of voting literature models lies in the differences in their algebraic symmetry groups. Voting models (including traditional Shapley-Shubik and Banzhoff measures of “power”) are invariant under monotonic transformations of the players’ utility functions. This implies that such models cannot incorporate considerations of the relative intensity of preference differences between players, for example, and hence cannot utilize the logic required to determine optimal threats and compromises in proper bargaining theory.

In contrast, the Nash-Harsanyi theory, and the closely related theory of axiomatic NTU valuation theory (for example, the Shapley values of games) requires players’ preferences to be invariant under the more restricted group of linear transformations of the utilities. Accordingly, their models make possible a proper theory of bargaining which, by its very nature, entails issues of relative intensity of preferences, as Harsanyi, Aumann, Kurz, Shapley, and other scholars have noted. In this vein, John Harsanyi in 1962 was able to formulate a general n-person measurement-of-power index useful in all conflict situations, a power index that is derived from bargaining power, as it should be. I have never seen a paper in the RC political science literature that utilizes this remarkable index, much less that acknowledges its existence. See, in particular, John C. Harsanyi, “Measurement of Social Power in n-Person Reciprocal Power Situations,” Behavioral Science 7, 1962.

Predecessor rational choice models could only measure power in voting situations, using interesting but limited concepts such as “swing vote power” and “blocking” power, as in the ordinal concept of the core of a game. But eyeball-to-eyeball bargaining proper cannot be modeled in such models. For a discussion of these issues, consider the arguments and references cited in Horace W. Brock, “To Each According to His Needs: An Axiomatic Characterization,” in Assets, Beliefs, and Equilibria in Economic Dynamics, eds. Charalambos Aliprantis, Kenneth Arrow, Peter Hammond et al. (New York and Berlin: Springer Verlag, 2004). See also Rational Behavior and Bargaining Equilibrium in Games and Social Situations, John C. Harsanyi (New York: Cambridge University Press, 1977).

4. The fundamental paper in this regard is “A Simplified Bargaining Model for the n-Person Cooperative Game,” by John C. Harsanyi, International Economic Review 4, 194–220, 1963. This paper synthesizes and unifies the different axiomatic valuation theories of Nash, Selten, and Shapley into a coherent whole.

5. These building blocks are analogous to those in a free-market model that consists of the producers (firms) and consumers, their preferences, their endowments, and market prices.

6. Nash introduced a set of reasonable axioms that a solution to the bargaining game must satisfy. He then proved that there is only one such solution satisfying these axioms. This is known as a “deductive proof” devoid of any behavioral interaction between the players. Harsanyi produced a “constructive proof” showing how the Nash solution results from a model of step-by-step human behavior during the bargaining process. The two approaches are fully complementary, but very different in spirit. Both arrive at the same solution to the bargaining problem.

7. Mathematically, this point happens to be the outcome with the property that it maximizes the arithmetic product of the utility gains of the players above their threat payoffs. The product—not the sum!

8. See Horace W. Brock, “To Each According to His Needs: An Axiomatic Characterization,” in Assets, Beliefs, and Equilibria in Economic Dynamics, eds. Charalambos Aliprantis, Kenneth Arrow, Peter Hammond et al. (New York and Berlin: Springer Verlag, 2004).

9. To express this more correctly, there will be a unique set of optimal threat strategies, the elements of which are equivalent with respect to the utility payoffs to the players. This is only true for two-person games.

10. I am deliberately sidestepping an important difficulty in bargaining theory that arises when players do not know the true strategy sets and payoffs of one another. This problem of “incomplete information games” was first addressed by John Harsanyi and Reinhard Selten in a bargaining context, and then later extended in an important way by Roger Meyerson of the University of Chicago, perhaps the leading game theorist of the next generation. In such games, each “player” is replaced by a set of potential “types” of players, one of which is the true one. Players then ascribe probabilities to the different types they could be playing against. Types may differ in terms of risk tolerance, or any other strategically relevant variables. The game is then played between these “types” rather than between the actual players. The original idea here, dating from 1966, was due to John Harsanyi. Much of this logic goes through, but in some cases matters become much more complicated. Based on my own research on “arbitration schemes,” I believe it is appropriate to approximate a game of incomplete information with a game of complete information in many cases, and then to proceed as above.

11. See, for example, the excellent summary of these developments by Kathrin Hille and Jamil Anderlini, “Red Alert,” Financial Times, June 3, 2011.

12. I am speaking of labor productivity here, not total factor productivity. As regards the latter, China has led the way in “factor stuffing” via its unprecedented investment program.

13. These statistics were cited in an article in the Financial Times on June 28, 2011.

14. Paul A. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (2004).

15. Robert Scott, Briefing Paper of the Economic Policy Institute, #260, March 23, 2010.

16. What gets funded annually by foreign investors is an amount equal to the size of the U.S. current account (trade) deficit. This funding is often referred to as the “net capital inflow” into the debtor country, in this case the United States. By the capital account = current account identity of international accounting, this capital inflow will and must always get funded by some subset of foreign investors. If some lose interest, others will take their place, typically at a lower and hence less risky value of the dollar.

17. Financial Times, July 1, 2011, 11.

18. Specifically, the equations characterizing the two games within the game are a set of simultaneous nonlinear equations that, when solved, yield solutions to both subgames.

19. In political science, there was the celebrated 1950 Arrow impossibility theorem, proving the impossibility of aggregating individuals’ preferences into social preferences. In economics, there were the theorems showing the near-impossibility of aggregating the microeconomic behavior of individuals into the macroeconomic behavior of groups, for example, the Ando-Simon-Fisher theorems.

20. In bargaining, there are in fact supply-and-demand functions for the payoffs from the game known as “utilities.” Lloyd Shapley in 1969 showed that an “equilibrium” supply = demand for utilities occurs when the payoffs to the players satisfied the two conditions of both efficiency and equity, properly defined. I extended this perspective much further in my doctoral thesis. See in particular Lloyd S. Shapley, Part 1 of “Utility Comparisons and the Theory of Games,” in La Decision: Aggregation et Dynamique des Ordres de Preference, Ed. G. T. Guilbaud (Paris: Centre National de la Recherche Scientifique, 1969).

21. Invited paper presented at the 1978 annual meetings of the American Political Science Association in New York.