Fairytale economic modelling ignores real world experience

11 June 2009

By Dr  Patricia Ranald, AFTINET Co-convener

The Minister for Trade this week released a study by the Centre for International Economics which claims to show, through economic modelling, that the Australian economy, measured as Gross Domestic Product, has grown faster than it otherwise would have over the last 20 years because of reductions in tariffs (taxes on imports).

He then used the study to attack those whom he claimed were seeking to retreat into protectionism by raising tariffs in a time of recession.

“Protectionism” is being used as a bogey word by governments in the current recession, with dire warnings of a retreat into the same protectionism that worsened the 1930s Depression.  The rationale for this is the memory of the extreme tariff rises initiated by the US in the 1930s, which did contribute to the global depression. But this is a false comparison with today’s conditions. In 1929 US tariffs on key traded goods were already very high by today’s standards, around 40%.  They were raised by an average of 8%, and provoked equally high tariffs in retaliation by US trading partners.  By contrast, the general level of tariffs in Australia is 3.5%, and no-one is proposing tariff increases.

Apart from addressing a phantom problem, the study itself has major defects when examined more closely. The study claims that the Australian economy grew by an additional 2.5-3.5 percent over the last 20 years because of tariff reductions. The media release then claims that “this translates to an extra $2700 to $3900 in real income each year for the average Australian family.”  Of course this made a good headline, with stories written as if this money had actually been delivered to every household.

This is misleading because the “average” family exists only in theory, and benefits from growth in the economy are not evenly distributed amongst families. As John Quiggin remarked years ago about a similar claim for household benefits from competition policy, “Don’t book your holiday yet!”

The study is misleading in yet more ways. Like all such studies, the figures are the result  of a mathematical  “model” of the economy based on totally unrealistic assumptions which are hidden in the appendices.  These assumptions exaggerate the benefits of trade liberalization for consumers and minimize costs like unemployment.   In this case, the assumptions  of the ORANI model, outlined in appendix B, include :

“In the long run the labour market is assumed to attain equilibrium, so that an economic shock has no lasting effect on total employment. This assumption is implemented by fixing the level total employment” (p. 39)

In other words, the model assumes that total employment in the economy did not change over the last 20 years. This assumes away one of the possible major negative effects of tariff reductions. In fact we know from unemployment statistics that the average levels of unemployment did rise steeply over the late 1980s and early 1990s, partly because of recessions, and partly because of structural changes caused amongst other things by changes in tariff policy.

But wait, there is another assumption about the trade balance (the difference in value between exports and imports). This assumption is

“In the long run, external balance is assumed to be achieved, so that trade shocks have no lasting effects on the trade balance.”

In fact, the trade figures over the last 20 years show us that Australia’s trade deficit has steadily increased, which means we are importing goods of far greater value than we export. Again the study has just assumed away a possible negative effect of trade liberalisation.

As Johm Maynard Keynes said in the 1930s about these absurd assumptions of neoclassical economics, “In the long run, we are all dead.”

But wait, there is still more! In the conclusions of the study, there is the following disarming admission about the impossibility of separating the impact of trade liberalisation  from other economic changes over the same period:

“Trade liberalisation, and the accompanying capital account liberalisation and the floating of the exchange rate were complementary parts of a wider set of economic reforms that occurred during the 1980s and 1990s. These reforms allowed a far more rapid expansion of the economy than would otherwise have occurred.

“While it is impossible to put precise figures on the benefits of any one part of the inter-related reforms, the transformation of the economy in terms of lower unemployment, low inflation, rising incomes, higher levels of wealth and greater stability, must be obvious to all” (p.32).  

In other words, the study admits that it does not establish any direct link between the claimed economic benefits and tariff reductions, because these cannot be separated from other changes!

Apart from the determination to ignore the actual experience of the recessions and high unemployment of 1987 and 1991, the real sting in the tail of the second paragraph quoted above is the phrase “greater stability”. It would be a kindness to the authors to assume that they completed the study before the onset of the greatest global recession since the 1930s, but this is not the case, since the study contains a chapter on the global financial crisis.

As the global meeting of 20 key governments (G20) convened to address this crisis has admitted, a major cause of the crisis was the deregulation of financial markets, and lack of regulation in areas like derivatives trading.  The Prime Minister emphasised these points in his critique of neoliberalism in the Monthly magazine. Most industrialized country governments are now re-regulating their financial sectors, despite the rhetoric of free trade agreements and neoclassical economic models.

The authors of this study and of Australia’s trade policy seem unaware of the contradictions between continued promotion of theoretical models of free trade agreements and financial deregulation, and the realities of addressing what is now a global economic crisis.