As indicated in my previous post on the FTA, the revised CIE study on the effects of the proposed Free Trade Agreement between the US and Australia has most of the benefits coming from investment liberalization. The estimated impacts on merchandise trade are now so small that a modest adjustment to the elasticities would turn the estimated gains to losses. As the report says (p98) “A high Armington elasticity implies that imports (from any source) are highly substitutable for local production, thus raising the prospect of trade diversion and income losses.”
Nearly all the gains proposed for the FTA therefore arise either from hypothetical dynamic productivity gains (the services gains are also mainly from this source) or from the supposed reduction in the risk premium for equity arising from capital market liberalisation. I’ve had my say on the dynamic gains hypothesis before, so I’ll focus on the equity premium.
First, as these results indicate, the equity premium is a really big deal. In the modelling present here, a reduction of 5 basis points (0.05 percentage points) in the equity premium induces a permanent increase in GNP of around 0.5 percentage points. The analysis assumes linearity as far as the gap between Australian and US equity returns is concerned, so we can take it further and say that reducing our equity premium to be equal to that in the US would raise GNP by around 12 per cent. Pushing the linear extrapolation further (further than it will go, but a reasonable first approximation), eliminating the equity premium altogether would raise GNP by around 60 per cent. I’ve done calculations in the past with very similar results, so I have no problem with any of this.
The difficulty is in the assumption that capital market liberalisation will reduce the equity premium and will have no offsetting adverse effects. The proposed changes are tiny by comparison with the floating of the dollar and the associated removal of exchange controls over the 1970s and 1980s, not to mention the associated domestic liberalisation. Yet there is no convincing evidence that these changes had any net effect on the risk premium for equity. Australian regulators who have to use a risk premium in estimating the cost of capital have looked at this issue repeatedly, and none has yet been willing to base decisions on the assumption that the risk premium for equity has declined recently, relative to the 20th century as a whole.
Then there’s the question of offsetting effects. The most important changes relax restrictions on takeovers. The analysis here is based on the assumption that such restrictions are necessarily harmful. Yet there’s ample evidence at every level to contradict this. The takeover boom in Australia in the 1980s, led by the entrepreneurs was cheered at the time by economic commentators using precisely the reasoning of the CIE. It’s clear in retrospect, though, that the entrepreneurs, and the “white knights” who opposed them, dissipated vast quantities of capital in the 1980s. In fact, the mid-1990s increase in multifactor productivity was due, in part, to the unwinding of the bad investment decisions made in the 80s.
Finally, there’s a question about process here. Comparing this report with the estimates made by the CIE in 2001 before the FTA was negotiated, it’s apparent that the trade gains have declined significantly, as would be expected given the unfavorable nature of the agreement. The response has been to add in hypothetical benefits so great that the aggregate estimated benefit is actually higher than before. Meanwhile, obviously negative aspects of the agreement, such as the extension of copyright and the changes to the PBS have been put in the “too-hard” basket. The fact that the observable choices have consistently favored the FTA supports the view that, in more technical areas like the choice of elasticities, there has probably been a similar tendency to make favorable rather than unfavorable assumptions. Thus, the dubious analysis of capital market liberalisation casts doubt on the analysis as a whole.
fn1. It’s true, as Harry Clarke pointed out a while ago, that the strongest finding is that takeovers are bad for shareholders in the acquiring firm. This implies that we ought to be willing to sell our own assets while discouraging overseas acquisitions by Australian companies. While I can see the logic in this, I’m not willing to push this argument to its logical conclusion.