The Economist has a new survey article on economic models: Economic models. Big questions and big numbers (July 13).
Economic models are widely used to evaluate the benefits of trade agreements:
...[General equilibrium] models were... a weapon of choice in the battles over the 1994 North American Free-Trade Agreement (NAFTA). The pact's opponents had the best lines in the debate—Ross Perot, a presidential candidate in 1992, told Americans to listen out for the “giant sucking sound” as their jobs disappeared over the border. But the deal's supporters had the best numbers. More often than not, those with numbers prevail over those without....
But how plausible were the numbers? Twelve years on, economists have shown little inclination to go back and check. One exception is Timothy Kehoe, an economist at the University of Minnesota. In a paper published last year, he argued that the models “drastically underestimated” NAFTA's impact on trade flows (if not on jobs). The modellers assumed the trade pact would allow people to buy more of the goods for which they had already shown some appetite. In fact, the agreement set off an explosion in the exports of many products Mexico had scarcely traded before. Cars, for example, amounted to less than 1% of Mexico's exports to Canada before the agreement. By 1999, however, they accounted for more than 15%. The only comfort economists can draw from their efforts, Mr Kehoe writes, is that their predictions fared better than Mr Perot's. A low bar indeed.
Dubious computations also helped to usher the Uruguay round of global trade talks to a belated conclusion in 1994. Peter Sutherland, head of the General Agreement on Tariffs and Trade, the ancestor of the World Trade Organisation (WTO), urged negotiators to close the deal lest they miss out on gains as great as $500 billion a year for the world economy. This figure came, of course, from a big model.
Even staunch free-traders, such as Arvind Panagariya, an economist now at Columbia University, thought these claims “extravagant” and “overblown”. They escaped scrutiny, he argued in 1999, because they emanated from “gigantic” models, which were opaque even to other economists. Why then did these models thrive? Supply and demand. “Given the appetite of the press and politicians for numerical estimates and the publicity they readily offer researchers, these models are here to stay,” Mr Panagariya concluded.
That appetite was undiminished at the onset of the next round of trade negotiations, launched in Doha, the capital city of Qatar, in 2001. Two years into the round, as trade ministers gathered for a summit in Mexico, the World Bank was pushing another extravagant simulation. It argued that an ambitious Doha agreement could raise global incomes by $290 billion-520 billion and lift 144m people out of poverty by 2015. Those figures found a ready place in almost every news report about the Doha round that autumn.
Such extravagance did not last. The World Bank has since cut these figures drastically, in part because the ambitions of the Doha negotiators have fallen short of the bank's expectations. One estimate made last year had cut the increase in global incomes to $95 billion and projected 6.2m people might instead move out of poverty. But even as they curb their enthusiasm for Doha, proponents of freer trade argue that CGE models do not show their cause to its best advantage.
However, Kimberly Ann Elliott notes that, in part, the numbers are also lower because of reductions in the levels of protection in the baseline: Can Doha Still Deliver on the Development Agenda? (IIE, June 2006). She notes:
Recent estimates of the potential gains from free trade are lower than previous estimates, and plausible Doha Round scenarios produce modest gains at best. Moreover, the gains from free trade are not evenly distributed, and the models show that some countries could suffer net losses from trade liberalization. It is important to understand why more recent calculations are lower, why many studies underestimate the potential gains, and why some countries could lose.
Are the Gains from Free Trade Lower
than Previously Believed?The short answer is yes but not for the reasons that people often think. The economists producing reports that show lower gains than in previous studies have not concluded that the benefits from a given amount of trade liberalization are lower than previously thought. Rather, the decline in projected gains across otherwise comparable studies is due mainly to a reduction in the measured level of remaining trade barriers. Antoine Bouet (2006) surveys a number of recent studies that use computable general equilibrium (CGE) models to estimate the gains from trade and explores the differences in assumptions and behavioral parameters that contribute to differences in results.
Two World Bank studies have attracted particular attention because the later one finds the gains from global free trade to be $100 billion lower than the earlier study, even though they use the same model and make similar assumptions (Anderson, Martin, and van der Mensbrugghe 2006; World Bank 2002). The principal reason for the difference in the World Bank results is that the baseline level of protection to which the free trade scenario is compared is lower than before. The change in the baseline results from both the inclusion of recent episodes of trade liberalization and improvements in the measure of protection used in most CGE models. The baseline reflects the phaseout of textile and apparel quotas after 2004, implementation of other Uruguay Round commitments, and China’s accession to the World Trade Organization (WTO). In addtion, scholars at the Centre d’Etudes Prospectives et d’Informations Internationales (CEPII) in Paris invested considerable effort to incorporate in the new MacMaps database lower, preferential tariff rates applied by rich countries to eligible developing-country exports. Most trade modelers, including Anderson, Martin, and van der Mensbrugghe (2006), now use this new database.
Back to The Economist:
Trade's virtuous effects are of two distinct kinds. First, trade helps countries make the most of what they already have. It frees countries to allocate their resources—whether they be cheap labour, fertile land or educated minds—as efficiently as possible. But, secondly, trade can also allow countries to accumulate resources more quickly. Indeed, the biggest prizes lie in faster growth, not heightened efficiency; in accumulation and innovation, not allocation.
By their nature, CGE models are better suited to capturing the first effect than the second. They provide “before and after” snapshots of the economy at two points in time. They are therefore good at capturing the one-off gains that might arrive from a redeployment of the economy's resources. They are much less good at capturing the continuing gains that result from a faster accumulation of capital, or a quickened pace of productivity growth. Most trade models, indeed, hold productivity fixed.
In a recent article, Dominique van der Mensbrugghe, of the World Bank, illustrates the much bigger numbers the modellers could produce given a free hand. He assumes that the very act of exporting raises the productivity of firms, because selling on world markets forces companies to raise their game while exposing them to new ideas and techniques. This alternative assumption raises the gains from free trade in goods by $174 billion (or thereabouts).
Paul at Truck and Barter also posted on this article - his post has a number of useful links: Trade and CGE Models (August 7, 2006).
Revised July 14 to add the Elliott quotation and on March 10, 2007 to add the link to Truck and Barter.
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