The FTA and the equity premium

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[1]. 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.

For future reference, I’ve pasted the relevant bit of the CIE report here. The whole report (PDF) is here.

A measure of the impact of these restrictions on the cost of capital in Australia can be inferred from analysing Australia’s equity risk premium compared with that of the US. The equity risk premium is the return on equities over and above the long term risk free bond rate.

At any point in time, the return on capital in Australia will differ from that in the US due to differences in country risk, expected movements in the exchange rate, the tax regime and the performance of the economy (which affects profits). But, by comparing the difference between the return on equities and the long term bond rate — the equity risk premium — some of these effects are netted out. In particular, the effects of country risk and expected exchange rate changes would apply equally to bonds as well as equities. If the effects of unexpected changes in profit could be removed, it could be inferred that some of the difference in equity risk premiums was due to restrictions on investment. Annual equity risk premiums can sometimes be negative, which is nonsensical since it implies investors require a negative return for assuming risk. The negatives (and large positives sometimes) arise due to bad (or good) luck.

Researchers, therefore, typically take very long periods of time when examining equity risk premia so the good and bad luck episodes cancel out. Dimson, Marsh and Staunton (2002) have compiled evidence on long-run international equity risk premia. Their findings suggest that the long-run (102 year) equity risk premium for Australia relative to the return on long term government bonds is 1.2 percentage points (120 basis points) higher than the equivalent measure for the US (Dimson, Marsh and Staunton 2002, p. 5). By using comparisons of equity risk premiums, the effects of currency

A risk and exchange risk should be eliminated so this 120 basis points difference will encompass several things such as Australia’s reliance on volatile commodities and the smaller size of the economy as well as any impediments to investment. It would be a major undertaking in its own right to assess how much of this apparent extra risk premium in Australia over the US would fall as a result of the partial liberalisation of foreign investment rules with the United States. Therefore, the most pragmatic way to approximate the possible size of this effect is to apportion the equity risk premium difference downward for several factors.

The first adjustment is that Australia has been liberalising foreign investment restrictions — although not as much as other OECD countries. But the effect will most likely be to narrow the spread in equity risk premium between Australia and the US. Also, some of the difference in the equity risk premium could be due to other factors mentioned above. But we are still left with the fact that Australia’s FDI rules are at the ‘restrictive end’ of the OECD scale. Therefore, we take a conservative approach and assume only half, at maximum, of the 120 basis points could be due to investment rules.

The second adjustment is that, so far, AUSFTA’s provisions on investment are on a bilateral basis. It is practically difficult to assign the relaxation of rules to just the United States. Nor is it in Australia’s interest to do so. While the decision is left to the government to make, it could be that the investment liberalisation is made on a MFN basis. How much difference this would make is difficult to say since the US, as the largest supplier of investment capital to Australia, is the major low cost supplier and investment margins can be easily arbitraged away around the world. In the absence of an MFN ruling on the investment rule change, a conservative adjustment would be to scale down the possible equity risk premium gap by the share of investment the US has in Australia (27 per cent).

The third adjustment is to reflect the fact that sensitive sectors are still exempt. US investment in the non-sensitive sector below the new threshold is approximately 66 per cent. These three adjustments point to an equity risk premium in Australia being possibly 10 basis points higher than necessary due to the restriction of foreign investment (60 x 0.27 x 0.66). Because there is little concrete evidence on the size of the effect on the equity risk premium, we act conservatively and halve the 10 basis points again. Until better evidence becomes available, we take a best bet estimate figure for the reduction in equity risk premium in Australia due to the changes in foreign investment rules as 5 basis points. As noted previously, no gain is attributed to the more certain investment climate for Australian investments in the US. The quantitative significance of this change for the economy is discussed in chapter 6.

49 thoughts on “The FTA and the equity premium

  1. to either JQ or JH I have neither the time nor the interest to read such reports which to my simple eyes appear to have a severe mercantilist bias ( for the gov’t?).
    I merely wish to know does the agreement encourage trade or does it divert trade?

  2. “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”

    John, you are assuming that the effect of capital market liberalisation in the FTA will simply be to make takeover of Australian companies easier. But what if it means that US companies decide to invest here in new businesses, not takeover existing ones?

    I know there aren’t any formal restrictions on them doing this now, but it can be argued that if the FTA creates a more favourable US-Aust business climate, then it will happen. Sentiment is hard to model, but it matters in business decisions!

  3. I have to disagree with Q on a number of points.

    First, Q implies that it would be easy to get a negative from merchandise trade by adjusting the Armingtons upwards. Not true, though understandable given the way it was written in the report. Increasing the Armington’s would increase some of the negatives in chart 7.1 (p83) but it would also increase the positives. It is extremely difficult to concoct assumptions that will turn the net impact of merchandise liberalisation negative. As chart 8.1 (p97) shows, the sensitivity analysis for the trade impacts (excluding dynamics and investment) suggests a 95% chance of a benefit ranging from $322 to $408 million/year (using the GTAP model, so not directly comparable with the G-cubed results widely reported).

    Second, Q says that the servcies gains come from dynamic gains – not true. It is true that we had to use a productivity shock in the modelling of services. However, this is because there is no other way to shock the model for increased trade in services where this comes about through foreign service providers establishing themselves here (or vise versa). The services shock is an honest attempt at calculating allocative efficiency gains – not dynamic gains. I would have thought Q would have appreciated the signficiantly more robust approach to services liberalisation (even if only because the number is lower).

    However, on the more substantive point – Q is right that the investment story drives the number. He is also right to say that it’s very difficult to perfectly measure the exact impact that the FTA will have. The report models a small convergence of the equity risk premium based on easier access to US funds – but obviously we can’t prove that it will be 5 basis points. Several people I’ve spoken to are convinced it will be more like 10… and I’m sure you can find people will a range of preferred assumptions. That’s why we provided sensitivity analysis and provided the results fully disaggregated.

    As for proof of equity risk premium changing over recent years – as the report says it can be impossible to correctly observe equity risk premium over the medium, let alone short, term. Hell, it can be hard over the long run! But that doesn’t mean it doesn’t change.

    Finally – to process. It is true that the estimates of trade gains has declined, as would be expected. This is not hidden. It is true that we have added the controversial dynamic benefits – but this is because (1) we believe it to be true; and (2) last time there were two reports written, and the dynamic one was done by somebody else – without quantification. This time there was just the one complete report. We quantify benefits whenever we can, because we believe it helps to sharpen the debate.

    The report was not written with the intention of having high investment numbers… but when that was what the model said, that is what we reported. It shocked me too. As for not reporting copyright (pp35-39) and PBS (pp58-60)… they are included in the analysis and estimated at no significant cost. Given the relative non-activity in these areas, this shouldn’t be surprising. As for Armingtons, we welcome debate on the appropriate levels, as we have nothing to hide.

  4. Scott – full report is free and can be found at (though it is long, and sometimes sounds like it’s written by economists).

    Homer – creation v diversion is only relevant for the allocative gains (not the dynamic or investment). Also, creation and diversion are only part of the story with merchandise trade (there are other factors such as terms of trade). The short answer is that merchandise trade liberalisation has a small net benefit. Chart 7.1 on page 83 may interest you.

  5. Scott, I’ve added a clickable link over the fold.

    John H, I have a question and a couple of comments. First, on the elasticities, I would have thought that the degree of substitability between US and ROW imports was very important, but I couldn’t find any discussion of this.

    My comment is that the problem with the equity premium issue is not just one of sensitivity. There are no good grounds to suppose that the effects you point to even exist and, if they do, that they will not be swamped by unmodelled adverse effects. The problem of home-country bias, for example, hasn’t even been addressed, nor has the adverse evidence on takeovers.

    On the PBS, the report says that the effects will be trivial, even though the process changes are very similar to those with FIRB, that is, having no obvious direct effects but much desired by those advocating them. Medicines Australia has predicted $1 billion in new investment, which must imply a very substantial increase in public expenditure. Both can’t be right.

  6. “On the PBS, the report says that the effects will be trivial, even though the process changes are very similar to those with FIRB, that is, having no obvious direct effects but much desired by those advocating them.”

    On the PBS, I’d argue that the Australian negotiators were steamrollered. In essence, the American side appears to have paid a reluctant lip service to the notion of current systemic integrity, in return for securing the potential for a progressive deconstruction of the public health primacy that underpins it.

  7. The CIE results hinge heavily on an implied reduction in the cost of capital via a reduction in the equity premium. Agreed. CIE have been conservative in assigning the reduction to the FTA but show, in a simple setting, strong magnification effects on capital stocks and income net of interest payments.

    I find it unsatisfactory that a key conclusion of their report depends on simple modelling (though it is clever and I couldn’t do better!) but their conservatism in estimating effects of FTA on the premium suggests they might have provided a lower bound. ‘Half of nothing is nothing’ (as I suspect John Q might retort) but I can’t believe effects on borrowing costs are zero. The recent move by Newscorp offshore and bleatings from the former BHP board concerning reduced capital costs from having a leg in London via the Billiton merger suggest advantages from modest increases in capital market integration.

    But I am not sure there is a lot in all this for economic analysis. The forecast effects by CIE on GNP are low in 10 years and the investment effects only 60 per cent of these.

    I wonder if other parts of the report are not more interesting particularly arguments that property right and PBS costs are low. And events are moving fast with forecast FTAs with China and ASEAN. These might increase conventional gains-from-trade from the US FTA by reducing trade diversion effects.

  8. Substitutability between similar products from different countries is covered by the armingtons. Effectively, both GTAP and G-cubed treat similar products from different countries as different products. The armingtons used were pretty much standard, and as the sensitivity analysis showed – changing the armington assumptions doesn’t reverse the results.

    I don’t think it’s quite right to say the changes to the PBS are similar to the changes in FIRB. The FIRB change is a direct change in the process of inbound FDI while the PBS change is about transparency of the current process.

    Harry – interesting that you bring up the last point about reduced diversion for future agreements. That is mentioned in the report, in chapter 7 (alternative global trade assumptions, starting p93)… but I really didn’t expect anybody to pick it up.

  9. Johns (i.e. plural)

    I’m interested to know how you’re reaching your conclusions on the equity risk premium regarding GDP growth.

    Surely this premium is just the price of risk. This price should only reduce if the risk itself is reduced (all else being equal), assuming the market prices it correctly.

    So are you really saying that the FTA may reduce the level of risk investors face? How does less risk equal higher GDP growth? This doesn’t make a lot of sense to me.

  10. Not being an economist I can’t sensibly enter into technical arguments about equity risk premiums etc. My perspective is that of a direct share investor and a private citizen armed with whatever common sense I might possess. Economists have been saying for yonks that geography doesn’t matter when it comes to the ownership of companies. Nevertheless the views of share investors and common folk are amazingly resistant to expert arguments. After being wiped out by the logic of their arguments our gut still tells us we’ve been snowed.

    Let me first try some common sense concerns.

    It seems to me that we have to decide what kind of a country we want to be. Do we want to have a series of world-class companies with world-class brands in the manner of the Dutch and the some of the Scandinavian countries, or do we want to become like New Zealand where all our major banks and great slabs of our major industries are owned off-shore?

    It is our willingness to trade away our autonomy in decisionmaking, in making laws, in creating our own culture that disappoints me most about this FTA. Where we have not completely caved in we have let the Americans have a foot in the door so over time they can increase their influence.

    This can be seen in letting them in on the decisionmaking process in quarantine and in the PBS. On the latter, all the focus has been on the final decisionmaking and the review process. David Tiley has drawn attention to how we have let them into every step along the way, which is why the Government can claim that final decisions are unlikely to be changed. The damage will be done well before that stage, if David is right.

    Lifting the non-FIRB takeover threshold to $800m is quite significant, I think. My marker companies are Adelaide Bank and GWA (mostly Caroma bathroom products, but also Sebel furniture and Rover mowers) where the market capitalisation is near the $800m mark. They are substantial companies with after-tax profit of about $60m. These are tiddlers to the Americans, but companies in the $200-800m range represent a category where much of the hard work in company development has been done and in many cases (not those two particularly) the growth prospects are far greater than companies like Telstra that are mature in their markets.

    We have to assume, I think, that many of our best will go. It happens already but will be easier in future, and we forgo the chance to place conditions.

    As a private investor seeking an income stream with better than CPI growth I can tell you that takeovers are a pain. After you have paid capital gains tax you have to hunt around with the remaining cash in hand to see whether you can replace the lost income stream with one of similar quality and growth prospects. It is often impossible.

  11. As JQ has pointed out, the key flaw in the FTA analysis is its reliance upon capital flows and investment:

    “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.”

    For a start, there’s no agreement on what the equity risk premium is at any point in time, and, further, it’s very difficult to explain why it changes when it does. It’s a very long bow to draw to say that facilitating capital flows will inevitably lead to a significant decline in the Australia equity premium. It is an unproven hypothesis, and a poor basis for trade policy.

    IMHO, if the FTA couldn’t stack up on the basis of real trade flows in goods and services, it shouldn’t have been done.

    One last point: has anyone modelled the dead-weight loss to Australian GNP from the handout that’s just been given to sugar farmers, and the effect it has on the net benefits of the FTA? If trade deals result in wealth transfers from productive areas of the economy to unproductive areas, are they really so beneficial?

  12. Fyodor – I agree that there is little agreement on what the equity risk premium is at any point in time and it’s hard to explain why it changes. However, we do know that one risk is political risk and we do know that lower political risk is better.

    It’s a tough call to estimate the size of the impact of the FIRB change on risk. It may be zero, or close to it (as Q and you appear to believe). It may be significant, as some other very good economists believe. As modellers, we are often faced with these situations were we have to make a tough, and not always popular, assumption. We went with a relatively conservative number (5 basis points) – but I can understand disagreement.

    However, even if you exclude all investment benefits – the FTA still provides a positive. Even if you exclude the dynamic benefits – the FTA still provides a positive. Even if you exclude services – the FTA still provides a positive. Even if you then take the bottom end of the sensitivity analysis – the FTA still provides a positive. You have to have a pretty active imagination to get a negative, though I’m sure some people will find a way!

    Regarding the sugar handouts – we have not modelled the impact of those, as they are a separate policy. But we will gladly do so. For a fee. 🙂

  13. Thanks, John (H). I appreciate that, being economists, you’d be expected to make some kind of assumption on investment impacts. No problem with that. The problem is that both the theory and the practice of the equity risk premium are so wobbly as to make the assumptions on that score meaningless. You implicitly accept that point when you state that, bottom-line, the FTA is good because of the “hard” gains on trade in goods, and that’s what it should be about.

    Yes, it is good – for those who believe in the benefits of trade, the reduction of some barriers is a positive. However, not as good as the Howard government seems to believe, and couldn’t it have been a damn sight better?

    I’m a supporter of free trade, but I think this agreement will go down as another lost opportunity for the Howard government. Moreover, the government’s immediate handout to sugar farmers demonstrates Howard’s rampant, unprincipled opportunism when it comes to the choice between rational economic policy and a few votes in marginal seats.

    I’d love to commission some of your research. Just let me get my US backers to fund it – apparently they’ve just realised they can invest in Australia!


  14. “The PBS change is about transparency of the current process.”

    That’s just a rumour JH. The obvious ‘change’ is largely a committment re-statement to the clarity that’s, pretty much, already available. It’s the less immediately obvious changes that concern me.

    Independent Review-but-definitely-not-an-appeal processes notwithstanding, there’s no real advancement on transparency at all. About 60%-70% of all applications to PBAC currently get up on first submission. Another 10% get up on resubmission. We’ve got a real problem with ‘transparency’ on those data.

  15. As modelled, the benefit of the FTA is dominated by the benefit of our reducing our barriers to US investment. Now that is modelled as part of the AUSFTA, but it’s one of the ‘concessions’ we are making. Its not a ‘concession’ we’re getting from the Americans. This has several implications.

    Firstly and most obviously we can get the same gains without the agreement – we just unilaterally liberalise investment rules.

    Secondly if we were to do that, we would do it for more than the US. So if the modelling is right we get bigger gains – maybe something like double those modelled.

    So the report is not really modelling the opportunity value of being in the FTA. Its modelling the success of the FTA’s tricking us into doing something that’s in our interests in any event. Trouble is, the baggage it comes with involves us tricking ourselves in to not doing it with the rest of the world.

    So its all in the presentation. One can present the FTA as having a value of x billion (because it tricks us into partially liberalising investment), or you can say it costs about the same amount (because it tricks us into not liberalising investment by the same amount for all.)

  16. Traditionally governments see trade liberalisation as a concession even if it gives unilateral benefits to the side giving the liberalisation. This applies to trade as well as capital flows. As previous postings (particularly John Humphreys) have suggested this argument works in a bilateral setting provided trade diversion costs are not excessive (and the country is a price taker in international markets). For example the US would gain benefits from having access to cheaper Australian beef net irrespective of what Australia did unless it was diverted from purchasing cheaper beef net of tariffs from a possibly lower cost producer, say Argentina — the gain in US consumer benefits would then outweigh the loss of US producer benefits plus lost tariff revenue. The same argument applies to capital flows (given no capital flow diversion effects, no possibility of an optimal tax/tariff on capital flows).

    If you liberalise trade in goods or capital with everyone then there will be unconditionally gains for the country liberalising and for the world as a whole. Free trade with everyone is unconditionally a good move for a price taking country like Australia ignoring distributional effects etc.

    So your point is right Nicholas it is just that (a) politicians don’t accept the trade theory case for global free trade and (b) this is a bilateral trade liberalisation negotiation.

  17. Dr Gruen brings up an interesting point. Potentially, the conclusion from this report is: “fine, the FTA is good… but why stop here – let’s liberalise all foreign investment”.

    I don’t think it’s fair to say that the FTA is going to prevent us from investment liberalisation with other countries. If anything – I think it’s likely to go the other way. We may be required by treaty to extend the liberalisation to Japan and NZ. And then why stop?

  18. I have a few reactions to the debate re the impact of the FTA on the FIRB and investment.

    1. It does not help the public policy debate, nor the standing of economics as a discipline, when the critical aspect of the results relies on a dubious and arbitrary assumption. The report would have been better if it concluded that the net economic benefits are likely to be small and probably positive. (This was essentially the line and tone that Peter Dixon adopted with his results were for the GST.)

    2. There are two aspects to the empirical results that appear to be important. First, while it is true that small changes in the cost of capital can have large impacts on the capital stock in these (essentially calibration) models, I have always been suspicious of the extent of the responsiveness. The profession has always had a lot of trouble getting a stable and clear relationship between investment and the cost of capital (or q or whatever). Thus, the long-run response here does not come from estimated behaviour but rather from a theoretical assumption. I would be reassured if a 5bps shift in the ERP had a sizeable impact on investment over, say, a two year period from a freely estimated equation.

    3. Secondly, the point that John and others have focused on, how can we say that the changes to FIRB will have any impact on the ERP at all? What’s involved is a reduction in the transactions costs of possible takeovers for a relatively limited number of firms. The reduction in costs will be small relatively to the costs that the company involved in the takeover would have to incur in its normal due diligence processes and it is problematic that there will be any change in the number of takeovers as a result.

    4. Related to this, it might be interesting to explore the impact of past changes in the FIRB legislation or in policy related to foreign investment more generally. For example, the changes being contemplated under the FTA are likely to have a much more muted impact on attitudes and incentives to invest in Australia than, for example, the Govt’s decision to knock back the sale of some of the NW shelf assets. If the proposed changes in the FTA are worth 5bps on the ERP, maybe the signals from the Woodside decision would be worth 25bps. (This also indirectly relates to Nick’s point – if there are no costs from the changes to FIRB because ‘national interest’ will apply in fewer cases, why not extend this unilaterally and get a larger reduction in the ERP? Or does relaxing the national interest test have some potential economic costs?)

    5. Finally, if small changes to the ERP can have powerful impacts on the capital stock and GDP, we should embark on a much more serious policy agenda to find ways to influence the ERP. The fact that the ERP seeems to be much larger than can be explained by standard theory means that there should be scope to do just that. One idea would be for the Govt to issue more paper and invest – in a suitably arms length fashion – in Australian equities. It would be more likely to achieve a 5bp shift thru such an approach than it is for the FTA to deliver this result.

  19. Here’s something that Ric Simes and I wrote a year or so back.

    “A central theme of economic reform since that time has been the idea that the economy does more than make things. It is a giant hugely complex mechanism that not only makes things but also trades them. Shining the light of economic thinking on existing restrictions on trade and on the competitive terms on which that internal and external trade takes place revealed major gains to be made from reform.

    That agenda needs to be continued. While this occurs we advocate integrating risk management more centrally into economic policy. If the economy is a giant risk management system, is risk well managed within our economy and can improvements be made? The potential welfare gains justify basing much of the next wave of reform on aspects of risk management.”

    As the CIE modelling suggests, if we really can improve risk management in our economy the gains are huge. Why don’t we focus on it? For most things the gains from reform are proportional to the square of the distortion, so there’s plenty of low hanging fruit about.

  20. Some goods points raised. In part, I am going to use one of Gruen’s points against Simes. Gruen suggests that maybe we should focus on reducing the equity risk premium – given how important it appears to be. However, Simes complains that we bring attention to the equity risk premium.

    Simes suggests that it is unhelpful to have the investment story highlighted, because (let me try to paraphrase) the necessary assumptions are not as robust as the assumptions required for traditional analysis of allocative gains from trade. But without highlighting it, we may not learn the important lessons, such as the one that Gruen brings up.

    After all, the only people to claim that model outcomes are supposed to be perfect are those who are trying to discredit modelling. The rest of us understand that the virtue of modelling is what we can learn in the process, and the broad story.

    Also, Simes suggests the report would have been better if it concluded that there are small positive gains. First – I should say that the report would have been worse if we started with the conclusion. The results are the results of the model – and it would have been irresponsible to change them to numbers that we think are more ‘appropriate’ politically. Second, it needs to be remembered that the numbers we’re discussing are relatively small. Less than $6 billion/year by 10 years time.

  21. “5. Finally, if small changes to the ERP can have powerful impacts on the capital stock and GDP, we should embark on a much more serious policy agenda to find ways to influence the ERP. The fact that the ERP seeems to be much larger than can be explained by standard theory means that there should be scope to do just that. One idea would be for the Govt to issue more paper and invest – in a suitably arms length fashion – in Australian equities. It would be more likely to achieve a 5bp shift thru such an approach than it is for the FTA to deliver this result.”

    Not surprisingly, this is exactly the implication on which I will be focusing

  22. Some reactions to John H’s comments:

    First, I have done plenty of modelling in my time and use models, and their results, all the time. My point was not to denigrate models, it was to emphasise that where the results are to be used in formulating public policy, you need to be sure that the results are robust. And the key results used in this exercise do not look very robust. Indeed, they rely essentially on calibrating some long-run theoretical assumptions rather than relying on estimates from empirical observations. And this is an area where the empirical support for a large impact from the cost of capital to investment and, in turn, the capital stock can hardly be described as robust.

    My point about suggesting that the report could have emphasised the small gains is that it appears to me that for those areas where the analysis is more robust, the gains are small.

    Finally, let me stress than I am all for lowering the ERP – hence the authorship of the piece that Nick quoted. It’s just I doubt that we have the mechanism to do so with the FTA. The FTA should sink or swim on its other attributes.

  23. ” The results are the results of the model – and it would have been irresponsible to change them to numbers that we think are more ‘appropriate’ politically.”


  24. I’am lost Rick. You claim the evidence connecting reductions in the ERP to increased investment is non-robust so best assume it is small and disregard it – in particular ignore it in assessing the FTA. This in itself not quite sound. But then you claim the ERP itself should be reduced as it will produce large economic gains (last sentence last posting and argument with NG)? So, your argument must be that the gains from reducing the ERP must primarily be other than through reducing the cost of capital. Can you elucidate?

    I think CIE were faced with a tough assignment and made conservative assumptions using ultra simple models (yes it was a simple model and data was used). I prefer results based more on evidence and better modelling but how to get it? By studying the effects of capital costs on investment demands –will this help?

    You seem to be saying CIE were insufficiently conservative but that nonetheless the ERP is likely to be important. Something wrong here but maybe I am missing something.

    John Q seems to slip into the same line with his support of massive public investment in equities to reduce the ERP. This he is sure will be effective but he is also sure that small reductions in the ERP won’t even create small aggregate cincome gains from the FTA.

  25. Harry, I think the argument is that there is nothing in the FTA which will reduce the ERP, so the benefits of reducing the ERP should not be counted as benefits of the FTA.

    I think it is pretty clear that the only the merchandise trade modelling is robust, and the modelled gains are very small. But surely the losses from the extra subsidies to the Queensland sugar producers should be counted too. These subsidies, even if not part of the FTA, flow directly from the existence of the FTA.

  26. Uncle Milton, a large fraction of FDI coming into Australia from our largest source of FDI is now no longer subject to FDI restrictions, there is some improved investor certainty and you are confident it is a collossal exaggeration to suppose the equity premium drops from 120 points to 115 points?

    The bitter taste of the sugar subsidies should be accounted for in assessing the FTA, I agree.

  27. Harry, I don’t think, in practice, that FIRB has stopped much, if any, US investment, so it’s actually been a non-binding constraint. I suppose, as I posted earlier, that business sentiment could improve. Whether that is worth 5bps on the ERP – who knows?

  28. Harry and Milt

    The subsidies to sugar are not in themselves welfare losses. Rather, they are transfers from Australian taxpayers to Australian farmers. That said, to some extent that may cause a continuance of uneconomic sugar farming, thereby inducing some welfare losses. However, it would be wrong to deduct $444 million from the (purported) benefits of the FTA to account for these subsidies, if that’s what you had in mind.

  29. I can’t speak for Harry, but what I had in mind was deducting the welfare losses from having resources devoted to inefficient sugar farming which be more productively used in other industries .

  30. JH ,
    Isn’t there a correlation betwen trade creation, dynamic gains and investment?

  31. Milton,

    Yes, I presumed that you both would be aware of the transfer vs welfare loss point, but thought it worth clarifying.

    A further point is whether the full extent of the sugar subsidies can be “blamed” on the TSA. My guess is that, in the run up to the election, the government would have provided some level of assistance to sugar farmers anyway, although the failure of the FTA to include sugar probably added to the pressure and resulted in larger subsidies.

  32. I’d attribute about half of the sugar package to the FTA failure (a fair bit is a repackaging of previously announced rescue packages). Of that, I’d guess about half will be a net welfare loss, ie. about $100 million.

  33. Much as been said about the implications of FTA for reducing capital costs by reducing risk. What about the effects of the FTA in securing Australia’s access to the world’s biggest market and helping Australia to guard against uncertain future opportunistic anti-dumping and other protectionist measures by the US directed against Australia? Isn’t our security against such risks enhanced by the FTA?

    In these terms the non-inclusion of sugar and beef in the FTA (and other areas where trade was not liberalised) become a side payment or insurance premium to help promote less risky access to this enormous market.

    Arguments that liberalisations result in reductions in low tariffs which provide welfare gains proportional to this small reduction squared make me feel uneasy, Accounting for effects of reducing risk in trade might create benefits large enough to restore my intuition which is that we are much better off with the FTA.

  34. Homer asks: “Isn’t there a correlation betwen trade creation, dynamic gains and investment?”.

    First, the gain that is reported as investment gains is totally uncorrelated with the trade gains. Gruen is right to say that we could get those gains without the FTA.

    Second, the trade gains (allocative gains) and the dynamic gains are linked in one sense – but not directly. The allocative gains are a function of many things, including the changes to tariffs in the US and in Australia and the relative efficiency of both of these countries vis-a-vis the rest of the world. The dynamic gains are a function purely of the reduction in our tariffs.

    Interesting that you ask the question, because the second point I made above was apparently lost on Prof Drysdale and Garnaut today at the Senate committee – which in my opinion should be a point of serious embarrassment to them.

    Harry raises another benefit of the FTA – which is decreased poltical risk due to the binding of some trade measures and more secure access on services. Like several other parts of the report, we did not quantify these issues. I should add that I do not believe our exclusions (both positives and negatives) will make a significant difference to the broad conclusions.

  35. John H, I don’t think you can just say these effects are minor. Many trade people believe effects of reduced risk in trade from FTAs might be substantial. An opportunistic trade restriction in the future could cost Australia much. Limiting such risks by guaranteeing market access might be an important feature of FTAs, indeed comparable to effects of reducing risks in asset markets and more plausible.

    Moreover they might be particularly strong with bilateral rather than multilateral agreements because they are more likely to have teeth.

  36. JQ makes a rough estimate of $100m for the welfare loss from increased sugar subsidies, consequent upon sugar’s ommission from the FTA. While some of the subsidies will no doubt sustain some otherwise unviable production, other elements of the package are intended to hasten the exit of marginal farmers, so I think its a difficult call.

    However, whatever the merits of JH’s estimate, it should be recognised that the sugar/FTA story gets more complicated again when one considers that a recent Productivity Commission report on the effects of industries in the Great Barrier Reef catchment found that the sugar (and beef) industries appear to be key contributors to coastal river silting and declining water quality in the reef’s lagoon. The implication is that these industries are not paying for all of the environmental and (external) economic costs – for example, on tourism – that their farming practices generate. Further, sugar producers also receive relatively high levels of government assistance, even without the recently announced package. Thus, it can be argued that an expansion in sugar production, as might have occured had sugar been included in the FTA, could have been welfare-reducing!*

    As I recall, in modelling the effects of liberalising trade barriers to sugar, the original CIE report did not address the externality issue. The latest one didn’t need to. That said, it does make the point that environmental problems are best addressed at source rather than through second-best interventions such as trade restrictions. Even so, perhaps we should not be too concerned that sugar was ommitted from the FTA.


    * …or, at least, not as welfare-enhancing as a straight analysis of the trade effects might suggest.

  37. Try again to emphasise my points on the risk-reducing effects of a regional FTA with an appeal to authority. Perroni and Whalley (1994, NBER Working paper) look at the issue of the structure of FTAs between small countries such as Australia and large countries such as the US. Essentially they see such FTAs as one-sided agreements where small countries with low bargaining power seek safe haven trade arrangements with larger countries. These small countries have to pay a price for the participation of the large – the premium reflects a side payment. This would accurately describe the Australian-US agreement in my view. The exemption of sugar and beef from the agreement and perhaps participation in the war against terrorism might constitute the side payment in the present case.

    These authors construct a simulation of the US-Canadian agreement and show that it would not be in the interests of the US to enter into such a regional FTA without the side-payment.

    The general conclusion is that such regional FTAs have little trade-liberalising substance and are as much if not more insurance arrangements. In this event the CIE study is primarily misdirected in looking for liberalisation benefits when the main issue is insurance – helping to secure more riskless access by a small country to, in the present instance, the world’s largest market.

  38. Harry, I’m a bit puzzled by the argument here. To be sure the US is a large country in most senses, and the practice in bilateral agreements has been for the US to dictate the terms.

    But given that US exports to Australia greatly exceed Australian exports to the US, I don’t see how this “safe haven” argument applies to trade and the FTA. Given that bilateral relationships inevitable mingle trade and politics, we are far better off dealing with US trade through multilateral approaches (eg WTO) where the two can be kept at least partially separate. Then we can respond to US trade restrictions with countervailing duties and are in a position to hurt them more than they can hurt us.

    Instead, we’ve allowed the dominance of the US in other contexts to put us into a position where they can dictate an utterly lopsided agreement.

  39. Of course it would be nice John to negotiate a multilateral agreement with WTO but these take ages and are difficult and hence, on this thread, we are discussing bilateral FTAs.

    Your argument about the comparative size of exports doesn’t seem valid to me. The issue is not the relative size of exports but the size of exports relative to a country’s GNP. A loss of US markets would cost Australia much more than a US loss of the Australian market when viewed in this way. The US is a very important market for Australia but the reverse much less so. Applying counterveiling duties would have relatively large effects on our economy.

    The agreement doesn’t seem ‘utterly one-sided’. Small direct gains occur to Australia with or without the equity premium reduction benefits and we have paid an insurance premium to gain more secure access to the major foreign market in the sense of gaining security against opportunistic protection measures by the US. And it is these gains which seem to me to provide most of the benefits to Australia from the FTA.

  40. Of course John if, as you say in another thread, the Labor Party can and should should “demand a renegotiation of the treaty” then the insurance argument loses force. If we can rip up or modify the agreement then so too can the US. Indeed loss of insurance value initiated by our actions alone would be a cost of this policy prescription.

    If you buy my argument this cost would be large unless the US is seen as equally flexible in its attitude to such agreements.

  41. Harry, are you saying that because much of our access to the US market is in the form of quotas (eg beef) we run the risk with no FTA of these quotas being withdrawn and assigned to a more compliant partner?

    Are you further saying that if Labor were so impertinent as to demand a renegotiation, we would find out how gentle they actually were with us this time?

  42. Brian. Yes on both counts. The US generally has greater ability to hurt us with protectionist measures than we do to it. The FTA gives Australia some insurance that, in the future, it won’t act opportunistically either to hand benefits towards a more compliant partner or support a local pressure group in awarding protection.

    And yes I think something like a forced renegotiation could have potentially serious implications for Australia in destroying this insurance value.

  43. Brian, The Canadian opposition apparently talked about renegotiating the Canada-US agreement prior to an election but chickened out when the costs became clear. They might never have been serious about doing so but just exploiting a bit of pre-election populist sentiment .

    One could imagine the costs to Australia of halfing beef or other quotas. Would the gains from a renegotiation exceed such costs even if the current FTA is not ideal from Australia’s viewpoint?

  44. The argument for an FTA as an insurance against risk has a simpler correlate reflecting non-risk-related size issues. Imagine large and small countries L, S that trade. S supplies a small fraction of L’s imports while L supplies a large part of S’s. Each imposes (Nash) optimal tariffs. Result: L imposes relatively big tariffs. So (its true isn’t it?) L would insist on a sidepayment from S (costly exemptions, transfers) if it was proposed both eliminate protection in an FTA.

    Markussen & Wigle, JPE, 1989 show this for Canadian-US trade. (They also show other things -e.g. increasing returns & capital mobility reduce optimal tariffs).

  45. Harry, it looks to me as though they’ve got us by the short and curlies!

    I imagine that Latham, Conroy will huff and puff, but will understand that eventually.

  46. Yeah the huff and puff bit I agree with. I doubt its much more than that and going into an election campaign it would be a bonus for the Government.

    I am not sure they have ‘got us’. Its just the solution to a bargaining issue. As John Nash showed more than half a century ago this depends on bargaining strengths — you only get a 50:50 split of the gains from trade if these strengths are the same.

    They aren’t and we dont. I am surprised that some see this as unfair rather than inevitable.

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