How to read media analysis of the China–Australia free trade agreement.Posted: November 17, 2014
But if you have to, here are some things to bear in mind. Ever since the Cobden-Chevalier bilateral trade agreement between France and England in 1860, these kind of deals have been massively overhyped. Real free trade is a great thing. Bilateral free trade agreements are often pretty inconsequential. Real free trade comes through unilateral liberalisation (as occured in Australia in the 1970s and 1980s) and through multilateral processes like the World Trade Organisation.
When you hear journalists or politicians talk of an ‘$18 billion’ benefit, that’s a pretty good sign they’ve got no idea what they’re talking about.
That number is derived from a modelling exercise undertaken in 2005. The number refers to a hypothetical agreement in force during the the period 2006–15. It’s calculated in 2005 dollars. It’s using 2005 projections for trade flows, exchange rates, output growth, terms of trade, and so on. It’s based on 2005 tariff schedules. It is, not to put too fine a point on it, a gloriously irrelevant number.
But even if it was true, what does it mean? This ABC report seems to think that it’s $18 billion of exports, but also $18 billion of ‘benefits’; while this ABC report just describes it as an ‘$18 billion deal’, which makes it sound like it cost $18 billion. The Herald Sun says ‘at least $18 billion in extra revenue into the economy’, whatever that means (capital flows? national income?). SBS announces that the deal is ‘worth’ $18 billion, which tends to suggest a net present value, but over what time period? Business Spectator went for the same construction, and the same vagueness, pausing to add in ‘at least’ before the dollar amount. (I have to admit I’m a little charmed by the combination of the specificity of $18 billion with the sunny ambiguity of ‘at least’. It could be $18 billion or it could be a trillion dollars, don’t ask us, we’re just journalists.) This 3AW report suggests $18 billion ‘injected’ into the economy, which makes it sound like investment. This confusion as to point and metaphor suggests to me that no one has really spent much time questioning where this number comes from, or what it means.
I have someone here to help them. The preëminent Australian economist and modeller Peter Dixon wrote a helpful little guide for this kind of question, from which I have extracted some choice cuts for your edification. Dixon begins asking what we mean by x when we say that a free trade agreement will bring x dollars worth of benefit:
Is it the FTA-generated increase in GDP? Is it the present value of all future increases in GDP that will be generated by the FTA? Is it the increase in GNP or the present value of GNP increases? Is it a measure of the impact of the FTA on private consumption or economic welfare?
In our case, the $18 billion (in 2005 US dollars – how many news reports have you read that failed to specify that we’re talking about US dollars?) refers to the second of these: to be specific, it’s the present value of 10 years’ worth of real GDP increases for a modelling of a China–Australia FTA that comes into effect in 2006. Express that in annual terms, and it’s barely a rounding error. (At the time, Australian GDP was about $800 billion a year.)
And it turns out we’re using the wrong measure:
GDP (gross domestic product) is not a legitimate measure of the benefits of an FTA. GDP is a measure of output. Under an FTA, Australia may produce more output (and thereby experience an increase in GDP). But Australia’s citizens may or may not be better off. If the increase in GDP is generated mainly by an inflow of foreign capital, then the extra output belongs mainly to foreigners. If the increase in GDP is accompanied by a terms-of-trade loss (a decrease in the prices of exports relative to the prices of imports), then even if we do own the extra output we may nevertheless experience a loss in consuming power.
So what should we use instead?
GNP (gross national product) is a better measure than GDP. GNP is GDP less net payments of dividends and interest to foreigners. Thus, GNP is a measure of the output we own. However, like GDP, GNP is still an inadequate measure of benefit because of terms-of-trade effects.
Indeed, in the 2005 modelling, the present value of increased GNP was larger than the present value of increased GDP for Australia and smaller for China, by about $4 billion. “The reason”, the authors explained, “can be traced through to the changes in each country’s terms of trade.” Whether an increase in Australia’s terms of trade is likely to be experienced as a result of this deal—which is much more modest than the modellers in 2005 assumed—is one assumption worth questioning. In any case, be suspicious of anyone quoting figures denominated in GDP to you: not because that in itself is necessarily an instance of overhyping, but because it suggests they may not know what they’re talking about.
Dixon summarises thus:
In general, it is wise to be very suspicious of quoted dollar numbers and of present values. Probably the best summary measure of the benefits of an FTA is the percentage increase in annual real consumption that it makes possible on a sustained basis.
And the questions don’t end there. Where are the gains supposed to be coming from?
Once we have figured out to what variable x refers, the next question is how did the modellers get this particular value. From what I have already said about clothing, it is clear that if the modellers are sticking to what they really know (resource-allocation and terms-of-trade effects), then x must be almost indistinguishable from zero.
So where do they come from?
If x is not tiny, then we know that the modellers have attempted to quantify intangibles and to simulate their effects. We are certainly entitled to ask what intangibles were quantified and on what basis. In analysing FTAs, modellers sometimes throw in an assumption that the agreement leads to technology improvements (productivity increases) in directly affected industries. For example, in an analysis of an Australia–China FTA, it would not be surprising to find an assumed improvement in productivity in the Australian clothing industry or perhaps an assumed improvement in productivity in Australian industries that export to China. These productivity improvements may occur, but they cannot be predicted with any certainty. In assessing modelling reports that assume productivity improvements, non-specialists should feel no shyness about demanding supporting evidence and questioning its relevance.
And there’s a larger problem. Many of the gains that accrue from a free trade agreement are not the market access our exporters gain in the foreign country. (Though in fairness, there are some, especially since China’s previous FTAs have led to discrimination against Australian exports.) When we cut tariffs on Chinese garments, they become cheaper to Australian consumers, thereby raising real income in Australia. Similarly, when we make it easier for Chinese investors to send their money to Australia, we gain tax revenue and wages for workers in Chinese-owned firms. But neither of these things require any action from China at all: we could cut tariffs and liberalise our investment regime without help from anyone else. And we could do it for every single country in the world, not just China.
When faced with a large value for x, non-specialist readers of modelling reports should look for illegitimate attribution. If analyses of the Australia- US FTA are any guide, then we can expect analyses of the Australia–China FTA to cite as a major benefit simplifications of Australian regulations governing Chinese investment in Australia. These simplifications will encourage Chinese investment in Australia, thereby increasing our GDP and capital stock. Even taking account of the discussion I have already given of GDP and GNP, an increased capital stock delivers genuine benefits to Australia by increasing Australian tax collections. But are these benefits legitimately attributable to an FTA? We can simplify our investment regulations and encourage Chinese investment any time we want to, quite independently of an FTA.
So the question isn’t: ‘how much additional national income will this agreeement give us?’ The question you should asking politicians is: ‘how much additional national income could you have secured for us by acting alone rather than spending ten years negotiating?’
And since we are now apparently contemplating beginning negotiations with India for a preferential agreement (don’t let’s call them ‘free trade agreements’), we should remember to include on the cost side of the ledger not only all the money spent by the government on negotiators’ overtime and the like, but also the benefits of the economic reform delayed in some deluded hope of retaining ‘bargaining chips’ for the negotiation.