The Senate Committee on the FTA held a roundtable meeting to which I was invited along with a fairly high-powered panel (listed below). Apart from the Andy Stoeckel and Lee Davis of the CIE, who were, naturally enough, defending the work they did for DFAT and Alan Oxley of Austa, the main pro-FTA lobby group, the evidence was almost uniformly against the FTA. Although there were a lot of different perspectives, there was, in the end, agreement on the point that the net welfare effects of the FTA on merchandise trade were sufficiently close to zero to be disregarded. Since these are the only effects for which economists have more-or-less reliable measuring techniques, this was somewhat discouraging, but it indicates that the terms in which the FTA have been discussed so far have missed the point.

The real issues relate to questions like services, intellectual property, the interaction between politics and economics, the US and Asia and so on. These are complicated, but most of the evidence suggested that the FTA will be a net negative, unless, like Oxley, you think that tying ourselves as closely as possible to the US is the optimal response to all these issues.

For what it’s worth the discussion reinforced the view I reached (with some assistance from Ken Parish) when the FTA came out .

The politics of this seem entirely straightforward for Labor. Hardly anyone in Labors constituency has anything obvious to gain from the deal (in fact, the immediate benefits for anyone in Australia are trivial and the indirect benefits entirely speculative) Latham has already alienated anyone who objects to standing up to the Americans. OTOH, the majority of the Labor base who objected to the Iraq war can see that Howard hasn’t even managed to secure fair treatment in return for our loyal support of the US, let alone any favours…the [standard] procedures for examining the treaty mean that nothing will come before Parliament until after the next election. It seems to me that this makes things even better for Labor. Rather than rejecting the treaty outright, they can say that, when elected, they will demand a renegotiation of the treaty (the fact that the US will also have an election complicates the issue, but mostly in a way favorable to this claim – for example, a statement by Bush that the terms of the agreement are ironclad can’t bind his successor).

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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.
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I’ll be participating in a Senate Roundtable on the proposed FTA with the United States next week, and things have been livened up with the release of a new study from the Centre for International Economics with the following optimistic bottom line

The most probable effect on macroeconomic welfare after a decade, as represented by real gross national product (GNP), is an increase of $5.6 billion per year above what it might otherwise be.

Not surprisingly I think this is estimate is way of the mark (warning: big JPEG coming up).
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I’ll be in Adelaide tonight, talking at the Elder Hall, University of Adelaide, 6;00pm to 8:00pm in a forum organised by the Don Dunstan foundation on ‘The Electricity Crisis: What Can be Done?’

I’ve been interviewed by the 7:30 report regarding the resignation of Bob Mansfield, the Telstra chairman. Unless something more newsworthy bumps it, some of the interview should go to air tonight. Those who don’t care about the visual component can read my general views on Telstra here, here and here.

On the proposal that led to Mansfield’s downfall, that Telstra should buy Fairfax, my reaction is “What were they thinking!?” Obviously the majority of the board could see howinappropriate this idea was for a company owned by the Federal government and directly controlled by the shareholding ministers. But even if Telstra were fully privatised, it would be a terrible idea for a major regulated monopoly to own large chunks of the press or, as in the previous proposal to buy Channel 9, TV.

Following up on the snippet below, I’ve done an estimates of the impact of the proposed Free Trade Agreement between Australia and the US, as it affects merchandise trade. My bottom line is that Australia loses about $1 billion per year, of which $800 million is a net transfer of tariff revenue to the US and $200 million is the deadweight cost of replacing the lost tariff revenue, net of reductions in the domestic deadweight cost of tariffs.

This estimate may be contrasted with the most optimistic one publicised before the FTA was signed, a benefit of $4 billion over 10 years or $400 million per year, IIRC.

I’d like to thank everyone who’s contributed to the debate so far, notably Harry Clark, Uncle Milton, John Humphreys and PM Lawrence. The discussion has helped me to sharpen up my own thoughts. Obviously what I’ve done is very preliminary, and I’d welcome more comments.
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One of the justifications I make for the time I spend blogging is that it gives me a chance to try out arguments I use in my work. With that in mind, I’d very much appreciate comments on this short summary of the role of ideas and interests in explaining policy outcomes.
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For about the fiftieth time, Saturday’s Fin editorial (subscription required), bemoans the unsustainable state of Telstra with its absurd mixture of public and private ownership. Yet at the time this structure was proposed, it was supported by the Fin and lots of others. When I observed that partial privatisation was the worst of all possible worlds, I copped plenty of flak for my pains. Although it was obvious enough that partial privatisation was a stalking horse for full privatisation, its proponents were quite clear at the time that it was a sustainable and desirable policy in itself, whether or not full privatisation ever came in.

So here’s my challenge, in two parts. First, is anyone who supported the partial privatisationof Telstra now prepared to admit they were wrong to do so? Second, is anyone at all prepared to defend the partial privatisation of Telstra [as an improvement on full public ownership in itself, not as a step towards full privatisation].

PS: I linked to the article above because of the discussion of Telstra, but I hope readers will forgive me for gloating a little about the accuracy of my analysis of the National Electricity Market, and the poor understanding of basic economics shown by many of its boosters.

Brad de Long correctly summarises the argument of my papers with Simon Grant. If you accept that the equity premium (the large and unexplained difference between the rate of return expected by holders of private equity and the rate of interest on low-risk bonds) is explained in large measure by the fact that capital markets do not do a good job in allocating and spreading risk, the the natural solution to all this is the S-World: Socialism: public ownership of the means of production This is because risk can be more effectively through the tax system, and through governments’ capacity to run deficits during economic downturns than through private capital markets. A very robust implication of the observed equity premium is that a dollar of investment returns received during a recession is worth two dollars during a boom – this provides governments with a huge arbitrage opportunity.
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Brad DeLong has had a string of posts referring to the possibility that some or all of the US Social Security fund should be invested in stocks rather than, as at present, in US Treasury bonds, of which the most pertinent is this one. This idea first came up in a major way in Clinton’s 1999 State of the Union speech, and has since had some play on the Republican side, especially now that privatization individual accounts seem to be off the agenda.

The key fact that makes the idea attractive is the equity premium, the fact that, historically the rate of return to investment in stocks has been well above that in bonds. This used to be explained by the fact that stocks were riskier than bonds. But ever since the work of Mehra and Prescott in the 1980s it’s been known that no simple and plausible model of the social cost of risk that would be generated by efficient capital markets can explain more than a small fraction of the observed premium. The immediate response, that of finding more complicated, but still plausible models hasn’t gone very far. The alternative explanation is that capital markets don’t do a very good job of spreading risk. For example it’s very hard to get insurance against recession-induced unemployment or business failure, even though standard models imply that this should be available.

Simon Grant and I have done a fair bit of work on this, with some specific attention to the Social Security issue. In this paper (large PDF file), published in the American Economic Review, we argued that substantial gains could be realized by investing Social Security funds in the stock market. We didn’t put a number on it, but I don’t find Brad’s half-embraced suggestion of $2.4 trillion in present value implausible.

An important point, though, is that investing in stocks will generally not be the best way to go, at least if the amount invested is large. A government agency holding, say 20 per cent of the shares in Ford and General Motors, would seem to have big problems. Leaving aside the specific institutional issues of the US Social Security fund, the obvious implication of the equity premium is that, unless there are large differences in operating efficiency between private and public enterprises, government ownership of large capital-intensive enterprises like utilities will be socially beneficial. The case is strengthened if monopoly or other problems mean that the enterprises have to be tightly regulated in any case. Again, Simon Grant and I have written this up, this time in Economica (PDF version available here)