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The dangers of intuitive economics

February 12th, 2004

One problem with the debate over the trade aspects of the “Free Trade Agreement” with the United States is that a lot of FTA supporters are inappropriately relying on intuition derived from arguments about free trade in a context where trade barriers are removed in a nondiscriminatory fashion. For example, Jason Soon says

Let’s note that unilateral lifting of trade barriers is almost always a good thing so the fact that the Australia has ‘given up’ on more trade barriers than the US is irrelevant. The fact that Australia under the FTA is now committed to the gradual phasing out of car and textile tariffs which hurt consumers is a good thing regardless of whether we get more access to the US market

and Stephen Kirchner pushes the same argument further.

The claim is valid in the context of a small country unilaterally reducing tariffs on a non-discriminatory basis. In this case, the world price is unchanged by tariffs, so the entire burden of the tariff falls on domestic consumers. Provided that the tariff revenue can be matched by a less distorting tax, reducing the tariff unilaterally will improve welfare.

This argument does not work in the case of a decision by country A to make a unilateral cut in tariffs for imports from one country (say country B), but not for others. In this case, in general, the incidence of the tariff cut will be shared between consumers in country A and suppliers from country B. Unless the distortions associated with the tariff are large, the net impact on country A will be negative. (This is a special case of the larger literature on trade diversion and trade creation, all of which casts doubt on the claim that bilateral free trade deals will be economically beneficial to the parties concerned). A straightforward first approximation to assessing the issues in the case of the US-Australia FTA is to look at the reductions in tariff revenue. As I mentioned in the post to which Kirchner took objection, this article states that

Currently, the United States pays 10 times as much as Australia does in tariffs in the joint trade between the two countries.

Except under extreme assumptions about elasticities, this implies that Australia will be worse off under the trade aspects of the deal simply by virtue of the associated revenue losses. Because our tariffs are already close to zero, these transfers will not be offset to any significant extent by reductions in deadweight losses. A straightforward calculation indicates that the deadweight loss from a 5 per cent tariff on imports is around 0.05 per cent of GDP. Since the US only accounts for something like 20 per cent of our imports, the associated loss is around 0.01 per cent of GDP or about $70 million per year, which is trivial in the context of tariff revenues around $1 billion per year

Of course, the trade aspects are less important than the issue of institutional integration, beginning with intellectual property and the PBS, but likely to extend in future rounds to issues such as privatisation, environmental regulation and taxation.

UpdateAlexander Downer has been quick to accuse critics of the deal of being anti-American, and Ken Parish takes a similar line, making the point that no similar objections were made to CER with New Zealand.

The implication is that I and other critics would have welcomed a comparable deal with, say, the EU, one which left the Common Agricultural Policy intact, but removed all restrictions on imports of European goods and gave Brussels the right to control Australian domestic policy, for example by prohibiting the use of any names for varieties of wine or cheese to which Europeans laid claim (a standard EU claim in trade negotiations, which we’ve acceded to on some occasions and rejected on others, comparable to the situation, until now with American claims on IP).

I suggest on the contrary, that most of those who’ve supported the FTA would agree with me in regarding such an agreement as outrageous (I make an exception for those who, mistakenly as I’ve argued, support all unilateral reductions in Australian tariffs). But perhaps I’m wrong on this, and such a deal would be welcomed with open arms.

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  1. February 12th, 2004 at 13:35 | #1

    John,

    A more comparable hypothetical trade deal with the EU would be one that (almost) completely removed barriers to bilateral manufacturing trade; allowed Australian companies to tender for government contracts in EU countries on equal terms to European companies; and completely removed barriers for many agricultural commodities, while achieving less than complete success on lamb, a ridiculously slow timetable on beef, and no movement on sugar. Personally I would welcome such a deal, and I’d regard ceding sovereignty over the names given to Australian wines and cheeses as an acceptable price to pay. The reason I’d welcome it is the one I explained in my post to which you linked: the danger of Australia suffering trade isolation if DOHA fails and the trend towards regional trade blocs accelerates. Separate bilateral deals with the US, EU (however unlikely) and China would effectively integrate us into 2 of the 3 main trade blocs to a sufficient extent to avoid being left out in the cold with the developing world.

  2. February 12th, 2004 at 15:47 | #2

    John,

    im a little confused, so please help out a poor non-economist (just a struggler whos trying)

    when you say the US pays 10 times as much as australia in tarrifs, what do you mean?

    do you mean the US consumers pay 10 times as much tarriffs on australian goods as we pay to our government on US goods?

    also, you say tarriff revenues of around $1 billion a year, do you mean these are what australian consumers pay on tarriffed US goods. wont removing these tarriffs free $1 billion of consumer money into the economy. (i guess its essentially like a tax cut of $1 billion to consumers of US goods)

  3. February 12th, 2004 at 16:34 | #3

    The PC reports that more than half of the FTAs they looked at were more trade diverting than trade creating.

    However, the value of FTAs for my mind is the increased competition caused by cheaper imports potentially leading to productivity improvements. I understand that John Quiggin is more skeptical than I about the productivity arguments for free trade – so I can see how reasonable people could here disagree.

    Also, if you are skeptical about the value of most government spending – the loss of tariff revenue isn’t as bad as it is for those with higher levels of faith in government.

  4. Jill Rush
    February 12th, 2004 at 20:12 | #4

    I have noticed that in political debate there seems to be a trend to label those against the Trade Agreement as anti American – Why not pro Australian? hen the labels come out so quickly it makes me think even more that we are not paying peanuts so we get rats – give me monkeys anyday.

  5. Brian Bahnisch
    February 13th, 2004 at 00:11 | #5

    I understand that our trade with the EU as a whole is greater than out trade with the US. Our government, however, seems often to take an anti-EU stance in trade matters.

    Back in 2001 the EU may have considered an approach by us. I read recently that they have put a stop on all bi-lateral deals, concentrating rather on their own expansion.

    There is a view (eg Vandana Shiva in India) that trade will be the death of us as a species. It’s a different paradigm, but should not perhaps be dismissed out of hand. After all our current experiment with civilisation is not very old. The ultimate test will be whether and how we emerge from the next ice age, when there may well be a thick slab of ice where Manhattan is now.

    But then I probably worry too much.

  6. February 13th, 2004 at 08:13 | #6

    actually if your worried about the next ice age you shouldnt be…

    you should be worried about clean drinking water…

    but dont worry…humans as a species arent going away…civilisation as we know it might…but even in the absolute worst case scenario…say nuclear winter or big asteroid…out of 6 billion of us…theres enough variation that a few of us will survive…

  7. John
    February 13th, 2004 at 08:46 | #7

    c8to – When I said the US paid ten times as much, I meant that US exporters paid ten times as much as Australian exporters (the immediate burden of the tariff falls on exporters to the country concerned).

    Part of the tariffs paid by US exporters is passed on to Australian consumers in the form of higher prices. In the limiting case where the Australian market is so small as to have no impact on prices at all, the entire burden of the tariff is passed on to Australian consumers. This is the case Jason and Stephen have in mind, but it seems unlikely to be a good enough approximation for a bilateral deal between Australia and the US.

  8. John
    February 13th, 2004 at 08:48 | #8

    Ken, I think you’re overreacting to the failure of last round of Doha talks. If non-bloc countries like Australia and the Cairns group had been willing to accept terms like those of the FTA, the US and EU would have been more than happy to give them to us. In fact, the offer on the table last time was a good deal better than the terms we have just taken from the US.

  9. February 13th, 2004 at 12:34 | #9

    Other wise intelligent unilateral free trade commentators, such as Kirchner, Parish and Soon, seem to be unfamiliar with the literature of technical economics.

    Free trade is about distribution as well as production, as the glorious trade triangle shows.

    Trade is about both tax-income and trade-output flows. Harry Johnson’s theory of the optimum tariff, showed the possibility that a tax on trade can capture some of the gains from trade, per monopoly, and deflect them to the imposting state.

    One thing that people need to wise up about the BUsh admin: politics is in control. They care not a whit for economic principles, only power and privilege. Thus nuclear game theory, rather than the theory of comparative advantage, is more relevant.

    The Bush admin are also self-confessed unilateralists, which in the context of hegemony entails a divide and rule strategy. This applies to international security and economy policy.

    It also applies to friends and foes alike. They are possibly attempting to establish the kind of dynasty that they denied their erstwhile enemies.

    I fear that some of our learned commentators are projecting their own well-intentioned primciples onto the Hobbesian animus of the Bush admin. The pro-fre thus confuse economic ideology with political reality.

  10. Brian Bahnisch
    February 13th, 2004 at 13:25 | #10

    What Jack said.

    c8to, I am worried about clean drinking water. Vandana Shiva worries about water just about more than anything.

    On the species, I heard on Radio National recently that about 70,000 years ago homo sapiens was down to less than 2,000 from which merry (or smart, or lucky) band we all come, according to the latest dna evidence. Neanderthal man, and homo habilis, who had been around for about 2 million years, weren’t so lucky.

    But then they say that the “y” chromosome is in a mess, is getting worse and is only good for another 125,000 years max.

    Sigh!!!

  11. Paul
    February 13th, 2004 at 15:57 | #11

    Re the consumer benefits of cutting the tariff on cars and textiles and footwear, is it utterly antediluvian to raise the issue of lost jobs in those industries? While the avoidance of job loss is generally an insufficient argument for protection, it deserves serious attention if the job loss affects certain geographical areas in particular and involves workers who are less likely to be easily retrainable.

  12. February 14th, 2004 at 08:10 | #12

    paul, why should the taxpayer pay the wages of people in poor industries. furthermore, why should they continue to pay for them because these people are unwilling or unable to retrain.

    certain industries are inefficent and become obselete. thats progress. but also certain industries have some sort of elevated status, say farmers in this, and other, countries, for whatever reasons. why should we continue to throw money into a problem thats not going to go away. these industries aren’t about to get better.

    if i were out of a job tomorrow there would be no bail out package…and nor should there be…

  13. February 14th, 2004 at 08:25 | #13

    john,

    i would have thought this is precisely the case. australia is 20 million to the US’s 300 million.

    why would american exporters be concerned about losing australia as a market, and thus carry a huge tarrif burden just so they could sell goods here.

    i think its probably correct that the australian consumer pays all the tarrif for the priveledge of buying US goods.

    to pick an example at random:

    a 2.0 litre ford focus LX in america costs 17,687 AUD (13,970 USD)

    from http://www5.forddirect.fordvehicles.com/Dispatch.jsp?fvppframed=false&referringSite=9&setSelectionFilters=BodyStyle.Sedan%7CModelGroup.LX&FVPPFlag=1&sModel=2004focus&sModel=2004focus&bHonorModelYear=true&sBrand=Ford&.CurrentState=FVPackages&partner=fv&partner=fv&handleModel=1&filter=BodyStyle.Sedan%7CModelGroup.LX&framed=0

    the same car in australia costs an australian consumer 28070 AUD

    http://www.ford.com.au/configurator/configurator.asp?vehicle=25&model=99&specificModel=201

    which is 59% more. so im pretty sure the australian consumer, and not the exporter is paying this tarrif (15% according to gittins)

  14. John
    February 14th, 2004 at 08:41 | #14

    I think you’ll find that the Ford Focus on sale here is made in Germany – American plants usually aren’t set up to produce right-hand drive cars. Also, your exchange rate calculation would have looked drastically different a year or two ago – this illustrates the point that incidence calculations are tricky.

    The crucial point is not the size of the market, but the number of competing suppliers of US-made goods. This is frequently small -two or three in many markets, only one in others.

  15. February 14th, 2004 at 10:31 | #15

    c8to, your analysis is consistent but wrong. There are a lot more things going on as well. Space is too short to go into any detail, but can I suggest you look over some of the pieces at my publications page, http://users.netlink.com.au/~peterl/publicns.html?

    However, here’s one single item to add to your analysis: Vagrancy Costs. Taxpayers pay for Social Security not because they are giving things but because they are – at one remove – buying something. It’s the same something Bismarck bought when he invented Social Security, a quiet life. The only alternative is to pay the costs of policing to keep an underclass down once it built up, and even if you have a practice of shooting street kids that’s still a cost.

    You can’t simply assume that present costs would continue, even if they didn’t jump immediately in response to cuts in Social Security, and even though today’s crime is mostly not driven by poverty. You would actually be reinstating Dickensian conditions, and after a time lag there would be Dickensian consequences as well as today’s sort of crime and criminal.

    Me, I see externalities in all this – but that’s covered in the material at my publications page I referred you to.

  16. February 16th, 2004 at 07:42 | #16

    the german produced ST model is not the same as the one i cited, but i have no idea where the LX is made, so who knows whether FTA would apply to it or not.

    Definately agree that exchange rate affects this, i forgot to put in that disclaimer.

    The point about competing suppliers, wouldnt having few or one supplier mean that they dont bother to lower prices (absorb tarriffs) in Australia.

    My general point is that i cant see that australia is a big enough market to worry about, that US exporters absorbing the tarriffs would be true.

    My feeling (which is obviously not a hard economic fact) is that americans are happy to sell the odd manufactured good here, as long as we are willing to pay for it.

    I accept my analysis was not an economic one, merely a rough example of my point about prices. sigh…i may have to get an economics degree.

  17. February 17th, 2004 at 15:34 | #17

    P.M.L. – taxpayers pay for social security because they are forced to. Whether it is right or wrong, lets not pretend that it is voluntary.

  18. February 18th, 2004 at 15:27 | #18

    I wasn’t suggesting that Social Security was in any sense voluntary (all taxes are distinguished by being “unrequited payments”), just that implementing it provided a general good. That’s the sort of thing where people claim there are grounds for intervention. (Of course, there are often even better solutions that don’t involve governments, and here the solution created yet another problem – see the material at my site for details.)

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