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Escaping from the Darkness of Ignorance:

Necessity of Scientific Evaluation of Preferential Trade Agreements

By. Mr. Lasantha Wickramasinghe

Mr. Lasantha Wickramasinghe is the Executive Chairman at Milco (Pvt.) Ltd since 2020. He started career as an Executive in the Production Planning Unit of Haycarb PLC. For over 13 years he worked at IFS R&D International (Pvt) Ltd., a leading IT company as an expert in the field of supply chain management and tax reporting principles in various countries. He has obtained a B.Sc. Degree in Mathematics (Special) Hons. from the University of Colombo. After that Mr. Wickramasinghe, obtained two MSc. Degrees in the fields of IT and Manufacturing Management respectively from the University of Colombo. He is currently reading for an MPhil/PhD in Philosophy (International Economics) from University of Colombo.

Ignorance is the greatest Danger

Preferential Trade Agreements (PTAs) have been in the crux of the political debate in the last decade of Sri Lanka. Unfortunately, the debate has been confined to a political debate and it has not gone into the required form of richness in the economic context. The economists who insist the government to rush to PTAs are merely advocating based on their beliefs or vested interests but not based on any scientific analysis. That has led many who debate on the advantages and disadvantages of free trade agreements even not to bother about how the impact of a PTA is economically assessed. In fact, we as a nation has been completely ignoring the necessity of any kind of a feasibility study before entering into such critical trade agreements which will create huge impacts, whether it is positive or negative, on our next generations.

This unscientific approach was fuelled by the argument that, “Any trade agreement would be beneficial” brought up by few activists. They believe that any trade agreement will automatically increase the welfare of the society. It is a half-truth that they themselves fuelled the argument while the other half of the truth is that they have been used to fuel this narrow argument which paved the way to eliminate the requirement of doing a proper feasibility study using the technical methods practiced by economists. The ignorance assessing the impact of trade agreements as a nation is the great danger, we are facing at the eve of discussions on Free Trade Agreements seems to be popping up again.

The purpose of this article is to have a brief look at what has been done in the field of economics to evaluate the impact of preferential trade agreements.

The debunked myth

Free trade and the protectionism have been subjected to debate for centuries among politicians, economists, policy makers and stakeholders of international trade. The argument of free trade is backed by the ‘theory of comparative advantage’ subsequently evolved by the works of Adams Smith, Robert Torrens and David Ricardo in the span of a nearly four decades in late 1700s and early 1800s. The leading economist who backed protectionism in the mid of 19th century is Friedrich List. Later, economists such as John Gallagher, Ronald Robinson and H. J. Chang backed the protectionist arguments although the literature conducive to free trade is dominant.

‘Multilateralism’, that is free trade for all without discrimination, which is trying to be achieved via GATT/ WTO arrangements and ‘regionalism’, that is two or more countries forming an area where free trade is practiced among partner countries while maintaining barriers to trade with the rest of the world has been the two major phenomena subject to pervasive literature of free trade. Before mid-1950s, mainstream economists believed that multilateralism optimizes the economic welfare of the world and Custom Unions and Free Trade Areas are subject to increase the world welfare to a certain extend as they bring some degree of liberalization. In 1956, Jacob Viner debunked this myth about Custom Unions and Free Trade Areas, using two concepts of ‘trade creation’ and ‘trade diversion’. Viner shows that PTAs are not necessarily welfare increasing but it depends, hence, ambiguous. Following the pioneering exertion by Viner, economists developed quite a few partial equilibrium models and general equilibrium models and continue to argue whether PTAs are welfare increasing or decreasing to partner countries, outsiders and for the entire world, and in what conditions. Another interesting debate is whether regionalism acts as building blocks or stumbling blocks towards multilateralism. While some economists see regionalism can be used as a vehicle to travel towards multilateralism some argues that regionalism dismantles the effort towards multilateralism dividing the world into several blocks which may tend to create future trade wars bringing back a pernicious situation similar to 1930s.

Computable General Equilibrium (CGE) Models to assess the impact of PTAs

The second-best nature of PTAs and the Vinarian explanation that the PTA can be harmful, suggest that ex ante (i.e. prediction before the event) analytical approach is necessary to anticipate the possible economic impacts of any given PTA. Entering in to a PTA can be considered as a major policy change by a country since the PTA might affect not only the trading with the partner countries but also the trading with non-partner countries and the domestic production, factors of production, production structure of a country, savings and investments, balance of payment, real exchange rate and gross domestic production as well. If the PTA is a comprehensive economic agreement, where the services and investments are also included, then the impact will be much broader in the areas such as intellectual properties, demographics, human rights, domestic legal framework etc. Therefore, the book published by Asian Development Bank titled “Methodology for Impact Assessment of Free Trade Agreements” clearly states that assessing the impact of a PTA before and after the implantation is utmost important for a country.

French mathematical economist Leon Walras pioneered the development of general equilibrium theory (1874) which is grounded in the neoclassical theories. K. Arrow and G. Debreu refined the Walras’s work to discuss the existence and the stability of competitive equilibrium (Arrow, K. J., & Debreu, G.,1954). However, these models were abstract and cannot be applied to real economic issues.

The models explained above were only capable of explaining the direction of welfare as the impact of a PTA. They are not capable enough to estimate the magnitude of the impact of the welfare of the economy. Also, these models are not able to account for the variety of commodities and trade policy changes caused by a PTA. They lack specific formulation to address the diversity and too rigid in their assumptions (Plummer et al, 2011).

Theoretical models of PTAs have usually restricted the number of countries and the number of goods in the analysis. These theoretical models also had no ability to model features such as economies of scale or imperfectly competitive markets. To overcome these limitations and to provide more relevant policy advice, researchers have turned to computer-based modelling. Computable general equilibrium (CGE) models were originated from the input-output models which were developed by Wassily Leontief. Input-output models represent the interdependencies of different sectors of the national economy by a quantitative economic model.

Numerical applications of general equilibrium were first introduced by Leif Johansen (1960) and Arnold Harberger (1962). Johansen (1960) made the first CGE model, a model for Norway with 20-commodities and 22-industries as a system of 86 linear equations connecting 86 endogenous and 46 exogenous variables. Harberger developed a model with two sectors called corporate and noncorporate to calculate the incidence of the US corporate income tax.

There are several topographies in CGE models which cause variations to the results. Those features are behavioural assumptions of the agents, market structure (perfect competition or imperfect competitions) and firm structure (scale of economies), model closure, the aggregation level of sectors, static versus dynamic nature of the model, the initial data set and obviously the range of liberalization considered in the model from tariffs and non-tariff barriers to foreign direct investments (FDIs) and services.

Baldwin and Venables theoretically explain that economies of scale incorporate more mechanisms to a CGE model to increase the impact on the welfare by a PTA. Empirical studies underpin this theoretical explanation. In general, surveys of empirical evidence by the CGE models used to analyse the effect of NAFTA (North American Free Trade Agreement) by Baldwin and Venables (1995) and APEC (Asia-Pacific Economic Corporation) by Robert Scollay and John Gilbert (2000), shows that second-generation CGE models which accompany scale economies to the model show more welfare gains than the first-generation models which assume constant return to scale. Third generation CGE models, which incorporate dynamics yields higher impact on welfare than static CGE models.

Beyond Tariffs for CGE Analysing

During the last two decades, the focus has been drawn into other non-tariff measures in the goods sector and to the services and investment sectors. In par with the developments taking place at the negotiation tables and policy forums, the attention of the CGE models also has been drawn into address such areas like reducing the barriers of tariff rated quotas, non-tariff measures, and liberalization of services.

Fugazza and Maur (2008) provided a quantification of the impact of the Non-tariff Barriers (NTBs) at the global level. The research discusses the methodologies that are used to model NTBs in to CGEs and arrives the conclusion that serious estimation and modelling efforts are yet to be taken. Hertel and Itakura (2001) analyzed the dynamic effects of the “New Age” FTA between Japan and Singapore. Other than analyzing the impact of proposed tariff cuts, the study has analyzed the impact of the implementing of a set of uniform standards for e-commerce in Japan and Singapore, liberalizing rules for trade in services. The study extends its analysis to evaluate the impact of customs automation procedures in Japan which makes them compatible with computer-based standards established in Singapore. The study used a modified version of dynamic GTAP model for capturing the impact of the features in this “New Age” FTA. Tarr (2013) built a policy based CGE models considering the dynamics of services, foreign direct investments (FDIs) and the endogenous productivity effects from services. Kitwiwattanachai et al. (2010) developed an extension to the standard CGE model to assess the impact of unemployment and real wages by four possible free trade area options for East Asian economies. Beckman et al. (2015) employ a static GTAP model to evaluate liberalization of several barriers in the agricultural trade under proposed Transatlantic Trade and Investment Partnership (T-TIP) between the United States and the European Union (EU). Strutt et al. (2015) employ a dynamic general equilibrium model (Dynamic GTAP model) projected to the year 2030 to assess the impact on New Zealand by proposed TPP where the model incorporates removal of tariffs and tariff-rated quotas on commodities, reduction of non-tariff barriers on trading of commodities, reduction of barriers on services, and improvements in trade facilitation measures.

Time to come out from the Ignorance

The knowledge is power. When many countries are using the knowledge as the power while we are indulged in ignorance, the results are obvious. All the other countries are doing feasibility studies based on such scientific models before going into FTA negotiations to assess the outcome of those. Unfortunately, Sri Lanka were trying to rush into comprehensive FTAs without doing any such systematic study but based on the fantasies of the economists and politicians who had no idea about the available and widely used methodologies of assessing the impact of an FTA.

The question is when and how we should come out of the ignorance bestowed upon us on free trade agreements. Should we allow vested interested activists to keep us in the darkness of ignorance in a context that light of knowledge is widely available?

We have started looking at this matter scientifically. Yet, this is only a beginning. We analysed the impact of proposed free trade agreements using a computable general equilibrium approach. We expect this endeavour will contribute to make the Sri Lankan approach a rational for the sake of our motherland.

You can access the report “The economic impact of the bilateral liberalization of goods in the proposed FTAs - Computable General Equilibrium Approach” via the following link.
Click here..

 

References:

Plummer, M. G., Cheong, D., & Hamanaka, S. (2011). Methodology for impact assessment of free trade agreements. Asian Development Bank.

Arrow, K. J., & Debreu, G. (1954). Existence of an equilibrium for a competitive economy. Econometrica: Journal of the Econometric Society, 265-290.

Baldwin, R. E., & Venables, A. J. (1995). Regional economic integration. Handbook of international economics, 3, 1597-1644.

Fugazza, M., & Maur, J. C. (2008). Non-tariff barriers in CGE models: How useful for policy?. Journal of Policy Modeling, 30(3), 475-490.

Kitwiwattanachai, A., Nelson, D., & Reed, G. (2010). Quantitative impacts of alternative East Asia free trade areas: A computable general equilibrium (CGE) assessment. Journal of policy modeling, 32(2), 286-301.

Beckman, J., Arita, S., Mitchell, L., & Burfisher, M. (2015). Agriculture in the Transatlantic Trade and Investment Partnership: Tariffs, Tariff-Rate Quotas, and Non-Tariff Measures (No. 1477-2016-121101).