Improving the Economic Modelling of Trade Agreements

May 20, 2020

Authors: Shanker Singham, CEO – Competere, Douglas McWilliams, Deputy Chairman – Cebr and Cristian Niculescu-Marcu, Director of Economic Analysis – Cebr

 

The Trade Bill setting out many of the key elements of the UK’s future trade policy post Brexit starts its second reading in the House of Commons this week. Meanwhile the government has published increasing amounts of material assessing the potential benefits of trade deals, most recently in the UK’s negotiating objectives for the UK-Japan FTA. For an informed discussion of the merits of different approaches it is important that such assessments provide a realistic view.

 

Unfortunately, the conventional assessments have a range of weaknesses that cumulatively mean that they tend to understate the benefits of trade agreements significantly.

 

The weaknesses of the existing analysis are at two levels:

 

  • First, there are technical reasons for believing that some of the assumptions which are conventionally incorporated into such analysis are becoming outdated.
  • Second we also believe that the published modelling underestimates the dynamic and longer term impacts that are likely to result from deep and advanced trade agreements. As Richard Baldwin and other trade economists have pointed out, trade liberalisation has a ‘juggernaut effect’ where initial steps in liberalisation trigger further liberalisation.

 

At a technical level, the biggest single weakness of the published reports is their reliance on non-tariff measure inputs that are heavily influenced by physical distance factors. The influence of such factors is likely to change as a result, as international trade moves further towards services and the manufacture of goods is increasingly impacted by AI and 3D printing, let alone the significant impact of increasing services trade.

 

Much of the existing modelling emphasizes tariff and non-tariff barriers and the contribution of trade agreements to reduce these distortions. However, there is also an opportunity to examine the impact of reducing anti-competitive market distortions, i.e. those that damage domestic competition as well as international trade. This of course goes hand in hand with having deep FTAs in place that can make these benefits realisable. We find that these impacts can be orders of magnitude greater than the border measures (including Non-Tariff Measures at the border) which the standard models are primarily designed to capture.

 

The models also underestimate the amount of linkage there is between the domestic regulatory agenda and the external trade agenda. The UK’s free trade agreement partners are likely to require significant divergence from existing regulatory settings, and so many decisions it would take to make its domestic regulatory environment more competitive, would be decisions its trading partners would also want to see.

 

Models should also reflect that the trade policy agenda outlined by the Prime Minister’s Greenwich speech for example (or David Frost’s Brussels speech) requires a substantial transformation of the UK economy itself, and certainly envisages a comprehensive external trade policy. If this can be accomplished, the gains would be significant – occurring both through traditional trade transmission channels as well as through the wider domestic economy.

 

A Cebr trade simulation study in 2019 showed, just on an illustrative basis, that synchronised domestic market liberalisation programme, coupled with international trade liberalisation produced an impact nearly four times larger than narrow trade liberalisation alone. Singham, Rangan and Bradley have developed an econometric model to evaluate the impact of optimisation of countries across the dimensions of open trade, competitive markets and property rights protection.

 

The models traditionally used may also be underestimating the benefits of increased innovation. Increased competition from trade agreements both creates the incentives for innovation (who can build a better mousetrap), and the enhances innovation powers more trade. These larger market spaces can drive more and better innovation. In particular, if the UK-US FTA allows (through its regulatory approaches) some of the US’s approach to innovation and entrepreneurship to rub off on the UK, this could have dramatic consequences.

 

The benefits of aligning with partners in agreements based on regulatory competition (with equivalence, adequacy and regulatory recognition) rather than harmonisation also needs to be considered. These benefits can be significant as it is more likely that regulatory competition will lead to a pro-competitive best practice outcome. It is not impossible for regulatory harmonisation to also lead to this, but it appears less likely that top-down systems will do so.

 

In summary, it appears that recent attempts by the UK government to evaluate the economic impacts of its future trade agreements have not included many of the most important effects of the kind of comprehensive trade policy (and therefore domestic regulatory choices) that the PM and his Europe advisor have suggested the UK should embrace.

 

Leaving aside the dangers of trying to model economic gains before an agreement has actually been reached, there seems little point in announcing the potential economic gains with the negotiating objectives. Singham pointed out the problems associated with the economic modelling which the Treasury had used in Plan A Plus (at pp 39-41). In most countries any economic effects of a trade agreement are simulated as part of a report on the trade agreement to the legislative body (see, for example the International Trade Commission report on the TPP). Even when these are done, the record of Treasury Department predictions about the benefits of agreements has not been great. As former NZ trade minister, Sir Lockwood Smith has pointed out the NZ government underestimated the benefits of the NZ-China FTA by about 500%. Partly this is because of the lack of models that properly capture regulatory and institutional improvements, and partly because it is impossible to model the benefits that accrue as a result of what Keynes termed the “animal spirits” of an economy. This is particularly true of the impact of these large economic spaces for entrepreneurs who spot market opportunities that they might never have done previously.

 

Recognising and prioritising the impact of a reduction of behind the border barriers and anti-competitive market distortions will enable general equilibrium models to be specified to more fully quantify the impacts of building larger markets.

 

We suggest using a bespoke general equilibrium model that draws on existing ABM modelling insights – which showed the benefits of reducing distortions through economies of scale micro foundations – both for inter and intra country trade.

 

It is important that the benefits of trade agreements are properly understood so that negotiators can prioritise their work, and so that the public can fully appreciate the costs and benefits of policy choices.