This article first appeared in the Newsletter of the Royal Economic Society in 2017. It is republished here with thanks.
Imperial College London
Michael Joffe, Imperial College, London, has written before in these pages about the development of what he calls ‘evidence-based’ economics, using the conventional wisdom about free-trade agreements to illustrate his case. Here he returns to the theme based on a presentation he recently made to the (UK) parliamentary International Trade Committee.
I have previously argued1 that the effects of free-trade agreements are poorly understood, and that the current type of study purporting to predict their effects is unsuitable for the task. The central problem is the existence of other major economic forces that are far more powerful.
Traditional economic prediction models lack credibility
I compared a highly-cited 1992 report predicting the likely consequences of NAFTA for Mexico with a 2005 assessment by the same authors, ten years after implementation. One non-NAFTA factor had dominated: the crash in the value of the peso, due to a current account deficit that could no longer be funded. The peso’s overvaluation had been discussed in the academic literature, but this was ignored in the NAFTA forecasts.
The predictions turned out to be wildly wrong. The exchange rate, current account and maquiladora employment moved in the opposite direction. Wages dropped sharply, rather than remaining constant. Competitiveness — the main justification for NAFTA — did increase in a few sectors, but by far less than predicted, and — like the employment increase — in the ‘wrong’ sectors. Even the increase in trade flows was mainly due to the crash in the peso value, not to NAFTA. I concluded that one could do better tossing a coin.
The 2005 report also mentioned some issues that had not been considered in the forecasts. One was ‘litigation by business firms against a broader range of government activity than originally envisaged’. Another was the sharp decline of small and medium sized enterprises, demonstrating that the introduction of a free-trade agreement does not turn a relatively unproductive manufacturing sector into a world-beating one — intensified competition can sometimes be detrimental.
What should replace them?
Rather than relying on the old fashioned, discredited approach that has previously been used, any appraisal of the likely consequences of different policy options should be based on an empirically-based causal analysis of the economies involved in any trade negotiations.2 The key is to describe the whole situation first, with an emphasis on trying to identify all the causal processes, including how they affect each other.
It is not as difficult as it may sound. There is broad agreement on the types of factors that could be relevant; the important thing is not to pre-judge what their impact may be, but rather to examine the evidence. Modern economics has generated a large quantity of high-quality evidence on a range of relevant issues, resulting from the availability of rich datasets plus improved statistical techniques, including causal inference. It is true that consensus has been difficult to achieve in many areas, but even when this is the case, adherence to a schematic account that is empirically wrong is worse than confronting the uncertainties that occur when dealing with the real world.
In this article,3 I focus on the economic information required for a possible UK-US trade deal as an example. To keep it short, I only provide an outline of how this could be done. Briefly, the first step is the broad causal description already mentioned. This includes an analysis of the strengths and weaknesses of different sectors of the UK and US economies. Special attention needs to be paid to important features such as the degree of competitiveness and productivity, as well as the extent of market concentration, regional factors such as the importance of particular plants to their locality, etc. This would include consideration of multiplier effects of large plants on the local economy, and of supply chains, both national and international. It is concrete and applied, not overly abstract.
Part of this is examination of the dependence of the various sectors on the regulatory framework. For example, US agribusiness is highly competitive, but this is largely because practices are allowed that are restricted in the UK and in the European Union more generally. Lowering of standards is not only important from the viewpoint of consumers, workers and the environment, but also a race to the bottom is against the interests of firms that maintain high standards.
This micro (or meso) analysis of actual industries also needs to be seen in its wider economic context, including the relationship with exchange rates, external debt, etc. The UK has a particularly high current account deficit (it is high in the US too), and that must be given its due emphasis.
The second step moves on from this baseline analysis to consider the range of options that might be included in an international agreement. Each of the elements of liberalisation is taken in turn: trade in goods and non-financial services, investment, financial transactions, and migration. The issues are different for each.
With trade in goods, liberalisation benefits the most competitive firms, as was seen in the case of NAFTA with a sharp — and unpredicted — contraction in the number of SMEs. The longer-term consequences of intensified competition could possibly have beneficial consequences for most (if not necessarily all) UK inhabitants, but this needs to be established by a thorough analysis of the strengths and weaknesses of different sectors, in the context of the broader economic environment. In addition, competitiveness is not always a result of greater efficiency; it could stem from adaptation to a different regulatory regime, as with US agribusiness.
The advantages and disadvantages of a particular policy option also need to be evaluated in relation to existing tariffs and non-tariff barriers. Clearly if they are already very low, the case for change is weak. And where non-tariff barriers exist, the disbenefits of lower standards of protection need to be weighed against any possible economic benefits.
International capital movements are of various types. The most important division is between Foreign Direct Investment (FDI), involving more than just movements of capital, as against strictly financial flows such as of portfolio or bank capital.
The benefits of FDI in the transfer of technology and knowhow, especially to lower-income countries, are well established. FDI has also played an important role in the UK economy for some decades, as in the car industry where British-owned manufacturers were largely replaced by foreign-owned firms that had superior managerial and technological qualities. It is universally recognised, however, that foreign takeovers of productive companies can be disadvantageous, as was seen in the case of Kraft and Cadbury, especially when it is the takeover of an already-existing firm. Dangers include asset stripping and plant closure. Considerable caution therefore needs to be exercised, as to whether such Mergers and Acquisitions should be facilitated.
It is empirically unclear whether there is any advantage to having foreign ownership of infrastructure, utilities or services, in the context of the UK. The experiences in the energy sector and railways, for example, are controversial. Part of the disquiet is because the owners are not accountable, even informally, to domestic opinion. The prospect of foreign ownership of, for example, parts of the National Health Service would be difficult to justify using evidence-based arguments of significant benefit. In addition, in essential services like healthcare, the risk will ultimately always reside with the British government, not with any foreign (or private) company. The case for an international treaty that would facilitate such changes is extremely weak.
With financial flows and transactions, traditional theory and evidence do not necessarily coincide. For example as Obstfeld (1998) noted, ‘economic theory leaves no doubt about the potential advantages’ of capital account liberalization, sometimes known as financial openness.4 However, the empirical literature does not consistently bear this out. There are some papers that claim to demonstrate that the mainly negative empirical findings are misleading, and that the received theory is correct if a particular approach is taken. However, these are not generally accepted, and the jury is still out.
More generally, international economics is replete with ‘puzzles’. These include: the Lucas puzzle concerning capital flows between rich and poor countries; the home bias puzzles in trade and in equity holdings; and the Feldstein-Horioka puzzle on the preference for domestic investment. These indicate that a chasm exists between traditional international economic theory and the real world. In all these cases, the observed phenomena are not difficult to explain. The puzzle arises when trying to reconcile the observations and explanations with standard theory.5
In relation to migration, as a general principle, the effects of any policy change should always be considered with an emphasis on the differential consequences for different groups — rather than what serves ‘the national interest’, which is an amalgam of several distinct impacts. This needs to be carried out in conjunction with the analysis of the differential sectoral/regional consequences of policy changes. The concerns are well known: possible pressure on employment, wages and working conditions, the strain on housing and services, and the ability of employers to avoid training their staff, instead importing already-trained workers (which is also a brain drain from the viewpoint of the exporting country). The evidence on these concerns is however unclear at present.
The phrase ‘free trade’ is widely used to cover trade in goods and non-financial services, FDI, and other international capital movements. But these all have different characteristics and consequences, so that a single term should not be used indiscriminately to cover such heterogeneous activities.
The East Asian experience clearly demonstrates that openness to international competition in goods can lead to growth and increasing prosperity. This depends crucially on the degree of competitiveness of the sectors involved; low-wage competition is not an option for economies such as the UK and the US, so competitiveness must depend on other factors, such as innovative products, hyper-efficient production or brand prestige. Also, state intervention of various kinds has been widely used in East Asia, especially restrictions on capital movements, so the success of trade openness in that region is not an argument for unrestricted liberalisation. Financial deregulation carries significant risks of volatility, and substantial countervailing benefit would need to be demonstrated for it to be recommended.
Even in the case of trade in goods, introduction of a trade agreement would not turn a relatively unproductive manufacturing sector into a world-beating one, and could destroy it, or at least have adverse consequences for employment, wage levels, etc. The likely consequences cannot be deduced from first principles in a simple, abstract way. The argument needs to be made, separately for each sector, after a thorough review of the empirical evidence.
Finally, in practice most trade is carried out by firms, and most international trade is carried out by large corporations. The dynamics of trade between individuals, the textbook paradigm, differs substantially from the dynamics of trade involving corporations. One implication is that corporate profits are a poor guide to gains from trade. This applies even in narrow economic terms, as with Kraft and Cadbury, but is even more important if the outcome for all stakeholders is considered.
1. Joffe M. 2015. ‘What do we really know about the effects of free-trade agreements?’ RES Newsletter No. 169, available at http://www.res.org.uk/view/art4Apr15Features.html
2. This approach has been highly successful in biology and other natural sciences, and it could readily be applied to the economy — there are already some examples of good practice. See Joffe M. 2017. ‘Causal theories, models and evidence in economics – some reflections from the natural sciences,’ Cogent Economics & Finance. http://www.tandfonline.com/doi/pdf/10.1080/23322039.2017.1280983?needAccess=true
3. This is because an earlier version was prepared as written evidence to the parliamentary International Trade Committee, for their work on UK-US trade relations — available at http://www.parliament.uk/business/committees/committees-a-z/commons-select/international-trade-committee/inquiries/parliament-2015/uk-us-trade-16-17/publications/
5. Joffe M. 2017. ‘Why does capital flow from poor to rich countries? – the real puzzle’. Real-World Economics Review.http://www.paecon.net/PAEReview/issue81/Joffe81.pdf.