By this point, it should be clear that “self-enforcing contract” is an oxymoron.

It doesn’t matter whether we’re talking about contracts in the so-called analog world, digital contracts in the digital world, or so-called ‘smart contracts’ (SCs) in the blockchain world.

Contractual self-enforcement is conceptually unstable because a contract, by definition, is a legally enforceable agreement.

As such, there is always the specter of third party enforcement bodies (e.g., C) that are extraneous to the contracting parties (e.g., A & B).

A ‘self-enforcing contract’ is like a ‘self-reading book.’ At first, it sounds good to automate a difficult underlying process, until one realizes that if the book is reading to itself, that defeats the purpose of the book — which is to be read by readers.

The same is true with contract. And the confusion around ‘smart contract’ self-enforcement only keeps growing.

There are a several reasons for this poor state of affairs.

First, many conceptual building blocks for today’s ‘smart contracts’ turned out to be doctrinally wrong, expressly contradicting settled global contract law principles. Second, separately from legal doctrine, self-enforcing ‘smart contracts’ are conceptually unstable because they offer no theory for solving the main objective of contract (enforcement), other than fiat pronouncements that automating performance is de facto enforcement. Spoiler: it’s not. Third, supposedly self-enforcing ‘smart contracts’ radically restrict contract parties’ autonomy — in both legal & functional terms. Fourth, even as the myth of contractual ‘self-enforcement’ gets debunked and the real costs of conceptual incoherence continue to skyrocket, many people — including many lawyers — believe that its impossible or impracticable to reverse the confusion. Fifth, instead of ending the confusion by returning to a more simple, doctrinally-grounded, and functional understanding of … contract, many SC theorists propose even more complex and elaborate taxonomies — including categories like ‘smart legal contracts’ and variously-styled ‘legal wrappers’ for SCs. Because of conceptual fragmentation, confusion regarding ‘self-enforcing smart contracts’ is likely to get worse before it gets better.

For this installment of the ongoing critique of ‘self-enforcing SCs’ we’ll dive deeper into economic theory on so-called optimal contracts, incomplete contracts, and/or implicit contracts.

Are there ‘Optimal Contracts’ — ?

Economist Oliver Hart is one of the highest profile theorists to use the term “self-enforcing” contracts. So it makes sense to launch into the myth of contractual ‘self-enforcement’ through his writing.

Hart is an economist who — along with Bengt R. Holmström — received the Nobel Memorial Prize in Economic Sciences in 2016, for an attempt to formalize a comprehensive Contract Theory.

The basic problem that Hart (and Holmström) try to solve is how to “optimize” contracts — that is, how to make sure a contract between parties contains the best terms for incentivizing cooperative strategies that fulfill the parties’ respective interests/expectations.

From the start, it helps to break the optimal contract problem into two parts:

There is an optimal substantive contract problem: what are good/“efficient” contract terms/arrangements/configurations in particular settings (e.g., executive compensation; loan agreements; etc.)? There is also a related, but separate optimal procedural contract problem: what are the ideal contract vehicles/forms for effectuating the “optimal [substantive] contract” — ?

From an economics perspective, the optimal [substantive] contract problem seems solveable if we can somehow gather enough information to understand what motivates parties in particular contracting settings.

Hart and Holmström’s optimal contract theory became so influential precisely because we could subject the substantive insights to rigorous empirical analysis across a broad range of settings, from corporate finance, to corporate governance, and employer-employee contracts.

Optimal Contracts With Full Information

In asymptotically-full information settings (e.g., executive compensation or large corporate mergers), it might be possible to conflate the substantive and procedural aspects of optimal contracts into a single problem of incentive alignment.

In his book, Firms, Contracts, and Financial Structure (Oxford University Press, 1995), Hart makes the following observation regarding the procedural implications of full substantive information flows.

Rhetorically, the parallels to ‘self-enforcing smart contracts’ are striking. We’ll come back to this shortly.

For now, please note how Hart and Holmström’s optimal contract theory breaks down in incomplete information settings and in multivariate contract settings, where parties may have different ‘irrational’ psychological and/or sociological reasons for contracting.

The best example of this is a basic residential rental contract.

Rationally, it might make sense to move to another property that offers, say, 20% cheaper rent.

If the cost of moving is less than the rent savings, it is economically rational for the tenant to move.

Yet, we know from personal experience and large-scale sociological studies that people exhibit certain contract ‘stickiness’ and ‘homing’ instincts that contradict supposedly rational economic choices.

Optimal Contracts ≠ Enforceable Contracts

Like the idea of ‘unbreakable contracts,’ optimal contracts are hypothetical creatures that do not exist in the real world. In their substantive form, optimal contracts can be thought of as asymptotic economic ideals that may work under narrow sets of assumptions.

But as economists routinely note, we should be careful about generalizing.

Just because a contract is optimal for A & B in an economic sense, does not mean the contract is enforceable, nor does it mean that contract should be enforceable. As between kids’ desire for pocket money, and employers’ desire for cheaper labor, an economically optimal contract may put those kids to work at ‘optimal’ wages for the employer. But we have child labor laws to block ‘optimal contracts’ like this, for strong public policy reasons.

It is extremely important to emphasize that Hart & Holmström theory of optimal contracts touches on, but is NOT focused on optimal contract enforcement modalities or processes.

The theoretical creature known as an optimal contract should NOT be confused with anything resembling an optimal [legal] contract form or template (eg, an ideal-type contract form that will supposedly accomplish the incentive-alignment objectives of an underlying deal).

This is because we don’t live in a world of full information and optimal arms-length contracting. And when legal disputes arise, even the most rational commercial parties often start to act in wildly irrational ways. Even their Nobel Prize citation makes this disclaimer: