the use of models in economic diplomacy

7/31/2019 The Use of Models in Economic Diplomacy

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The Use of Models in Economic Diplomacy..

Is It Really Effective?

Dr. Amal Nagah Elbeshbishi

Regional Advisor on Trade

African Trade Policy Centre

Regional Integration, Infrastructure and Trade Division

United Nations- Economic Commission for Africa


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Outline

I. Introduction.

II. Why Do Policy Makers Need CGE Models?

III. To What Extent CGE Simulations Can Be Relied OnIn Developing Countries?

IV. Challenges and Recommendations.


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I. Introduction

Economic models in general and Computable GeneralEquilibrium (CGE) models specifically are widely used ineconomic diplomacy, and have formed the basis for policyadvice to developing countries on the potential impact oftrade liberalization on their economies.

CGE models are computer- based simulations, likelaboratory experiments. They compute how todayseconomy will look like in the future as a consequence of a

special set of policy changes. Policy makers can take thesimulation results into account as they consider theiroptions.


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I. Introduction (Contd)

Various global CGE models have been used for trade

policy analysis, these include for example: the Michiganmodel of world production and trade; the G- Cubed model;the Global Trade Analysis Project (GTAP) modeldeveloped by the center for Global Trade Analysis atPurdue University; and the LINKAGE model of the WorldBank.

Clearly, there are differences between these models interms ofstructure, assumptions, database and choice ofmodel parameters.


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Most of these models show that:

There are global gains from trade liberalization.

There are winners and losers as a result of tradeliberalization. Whether or not a country derives benefitswould depend on the type of goods it imports and exports,

and its ability to respond to potential market opportunitiesto be created by liberalization. More specifically, countriesthat are net food importers as well as those that face severesupply constraints are likely to incur welfare losses. Inmodels with a high level of aggregation, this effect does not

appear in the results, as losses are compensated for by thewelfare gains of other countries in the region. Thus it isimportant to achieve a fine level of regional disaggregationin the simulations to identify the winners and losers fromtrade liberalization.


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There is no doubt that CGE models have contributed to

economic policy formulation. However, in recent years theyhave been subjected to serious criticisms, for example:

These models are typically aggregated to a degree that canobscure important underlying relationships;

Data are not always of high quality and some data may bemissing;

Estimates of the responsiveness of supply and demand toprice changes are not necessarily accurate;

Choices among scenarios and model specifications canimply very different results;

Static simulations are likely to miss crucial parts of thestory and dynamic simulations are more complex driventhan static ones.

Most modelers are, of course, well aware of these problems,but the same way may not be true for policy makers.


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Why do policy makers need to concern themselves with

CGE models?

The basic answer is that the use of these models should help

improve policy making.

The policymaker may have formed a judgment that tradeliberalization for example will be good for the country.

A simulation of the model can confirm that judgment and

provide an estimate of the likely gains.

Model simulations can surprise the policymaker and alerthim to some of the unintended consequences of his action

that would not have been clear without the economy- wide

framework and discipline of economic models.


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(Contd)

Thus CGE models are valuable as a tool for:

Confirming policy makers insights or validating intuitionabout the likely effects of a policy;

Alerting policy makers to unanticipated consequences of apolicy;

Understanding how a policy works its effects through theeconomy;

And developing a global rather than a local perspectiveabout the impact of the policy.


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(Contd)

While models should complement or improve policyanalysis, they are not a substitute for it. Simulation resultsare necessarily subject to error and the quality of theresults will vary with the appropriateness of the model tothe problem at hand, the quality and timeliness of the data

and parameters chosen.

The results of CGE simulations are only as good as thespecification of the models and the data that are fed intothem. Because information about an economy and the wayit will react to changes are never perfect, one can havelegitimate reservations about precise model results.

Policy makers will need to exercise judgment on how far

model results should drive policy making.


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(Contd) CGE models are recently used in economic diplomacy

especially in developing countries. In fact, the termeconomic diplomacy is of recent origin as well.Economic diplomacy was earlier known as tradediplomacy. Trade diplomacy came with the nationalizationof industries in many countries from the 1950s to the1970s. This resulted in gradual involvement of diplomats intrade matters that is to sell products of nationalizedindustries.

Economic diplomacy can be described as formulationand advancing policies relating to production, movement orexchange of goods, services, labour and investment in othercountries.


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(Contd)

Economic diplomacy is concerned with the prediction ofoutcomes of future trade regimes and therefore it will needan understanding of market factors at work in a givenglobal economic environment and in that process, acountry will involve in making decisions in advancing

economic interests.

A distinctive feature of economic diplomacy is that privatesectors are involved in the decision- making process toinfluence negotiating position to remain in the global orregional competitive market.


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(Contd)

Globalization of economy has greatly increased the rangeand variety of economic diplomacy. The range of countriesactive in economic diplomacy has expanded and nowspans the whole globe.

To pursue economic diplomacy presupposes that theremust be a pool of skilled persons in the government andprivate sectors to understand and negotiate key economicissues from national perspective, that explains why do

policy makers need to concern themselves with CGEmodels, simply because the use of models should helpimprove policy making.


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(Contd)

Modelers sometimes can be effective partners of policymakers. Economic modeling can provide the necessaryanalytical support for policy making. Everything else beingheld equal, those who have numbers normally triumphagainst those lacking them. And those who have better

numbers can expect to succeed more often.

While there are indications to show that CGE models arenow being more widely used by policy makers around the

world, it is more difficult to determine how much all thishas improved policy formulation.


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III. To What Extent CGE Simulations Can Be

Relied On In Developing Countries?

This section highlights issues that need to be addressed inthe design of CGE models so that they can capture

important features and dynamics of developing countries

economies and increase the likelihood of obtaining realistic

results from the simulations. The analysis will focus on

three areas: the theoretical framework; the database; and

the behavioral parameters.


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Relied On In Developing Countries? (Contd)

The Theoretical Framework:

Most CGE models introduce product differentiation byassuming that imports and domestic goods are imperfectsubstitutes in demand. This follows the work ofArmington(1969) and has the implication that each country is the solesupplier of its products and so can affect the price of theproduct. Clearly, the assumption that countries are largeenough to affect the market price of their exports isdifferent from what we know about developing countries.

With the exception of a few products, exports of mostdeveloping countries represent only a small fraction ofworld exports and so they cannot affect the world prices oftheir exports.


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The Theoretical Framework: (Contd) The Armington model explains international trade as

entirely intra- industry trade in differentiated products(how about inter- industry trade in homogenousproducts?).

The general equilibrium properties of an Armington modelare very sensitive to the magnitude of the Armingtonelasticities.

When the value of Armington elasticity turns from greaterto smaller than unity, the general equilibrium propertiesand the behavior of the Armington model change

completely.


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The Theoretical Framework: (Contd) Although most CGE models use above- unity Armington

elasticities for most industries, low Armington elasticitiescan still be found in certain industries. These are reasons tobelieve that the Armington elasticities used in current CGE

models may be inconsistent with their database. This isbecause the magnitude of Armington elasticities is likely tobe affected by the level of aggregation of an industry.

In order for Armington models to behave reasonably,domestic and imported goods have to be gross substitutesin consumption. This requires Armington elasticities to bereasonably large, often well above unity.


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The Theoretical Framework: (Contd) The Armington model tends to produce results that

emphasize the exchange gains from trade. The explanationfor trade being entirely intra- industry in nationallydifferentiated goods makes the Armington model incapable

of capturing the gains from resource reallocation orcomparative advantage.

There is the need for CGE modelers to revisit this

assumption to capture more accurately the features ofdeveloping countries' economies.


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The Theoretical Framework: (Contd)

As we know from economic diplomacy, trade negotiationis a bargaining game and the nature of interactions and theavailability of information affect the outcome of the game.

Strategic behavior among countries is completely ignoredin CGE models. Big countries or groups such as the UnitedStates and the European Union are in a better position toinfluence the negotiations and this has serious implicationsfor developing countries. This issue needs to be taken into

account in the use of CGE models in developing countries.


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CGE models neglect some forms of market imperfectionssuch as those in credit and factor markets of developingcountries that have serious implications for the ability of

these countries to take advantage of potential tradingopportunities created by trade liberalization and should betaken into account in the modeling exercise. The presumedeconomic benefits of trade liberalization are unlikely to berealized in developing countries if product markets are

liberalized without addressing credit and factor marketsimperfections.


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One of the key assumptions made in CGE models is thattrade liberalization has no impact on government revenue.This is implemented by altering domestic taxes in response

to changes in trade tax revenue so as to leave totalgovernment revenue unchanged after trade liberalization.This is based on the unrealistic assumption thatgovernments can fully recover lost tariff revenue byswitching to domestic taxes. Empirical evidence shows

that poor countries that adopted trade liberalization failedto recover most of the lost revenue by switching todomestic taxes.


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CGE models do not take adjustment costs into account.

This arises from the fact that most of the models tend to be

static and assume full employment of labor which isproblematic because it is inconsistent with empirical

evidence.


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Most CGE models of trade do not address issues related to

risk. However, one of the key concerns of developing

countries in the negotiations is that trade liberalizationwould expose them to external shocks. Developing

countries are vulnerable to trade shocks because they

export a small number of products with volatile prices. To

the extent that trade liberalization increases their exposureto risks, this ought to be taken into account in CGE

models, as they will definitely affect welfare changes to

developing countries.


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TheDatabase:

The availability of high quality and comprehensive data iscrucial to CGE analysis. Therefore if the database used forsimulation does not accurately capture the current structureof the economies under investigation, it is difficult to haveconfidence in the results of the analysis.

Due to data limitations in developing countries, some ofthem are classified into composite groups; this level of

aggregation does not recognize the heterogeneity amongdeveloping countries and does not permit researchers tomeasure the impact of trade liberalization at the nationallevel.


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The Behavioral Parameters:

The behavioral parameters measure the responsiveness ofproducers and consumers to relative price and income

changes and therefore have an important bearing on theoutcome of a CGE simulation.

One of the important criticisms leveled against CGEmodels is the quality of the information used to derive

these behavioral parameters. In some cases, the CGEmodelers do not statistically estimate these parametersthemselves but take them from other sources.


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The Behavioral Parameters: (Contd)

In other cases they make choices of these parameters basedon subjective judgments or take them from econometricestimates obtained using data not related to the period

covered by their simulation. While databases may beregularly updated, the estimates of the parameters are not,so some of the behavioral parameters are based onestimates that are about 15 years old and so do not reflectthe current structure of the economies under consideration.

The high degree of uncertainty surrounding estimates ofthese key parameters suggests that we should be carefulabout making strong and unqualified statements regarding

the impact of trade liberalization on developing countries.


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IV. Challenges and Recommendations

In recent years, there have been many CGE models thatdiffer in terms of structure and often give different answersto the same questions.

This is a source of confusion for policy makers especially

in developing countries where there is a lack of adequateanalytical capacity to evaluate the results of these models.

Several developing countries do not have adequateresearch capacity to conduct analytical studies on keyissues of interest to them and so they often rely on resultsof research carried out by international institutions andacademics.


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(Contd)

When researchers present results that differ significantlyand there is no explanation as to why these discrepanciesoccur, policy makers find themselves in a very difficultsituation because they do not know how seriously to takethe results. In particular, they do not know which of thestudies is more accurate and relevant to their situation.

Unlike policy makers from developed countries, developingcountries policy makers are often not in a position toevaluate these studies to determine how credible and useful

they are as bases for policy formulation. This can lead toone of the following unattractive responses by developingcountries' policy makers:


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(Contd)

The first is that they may use the results of these studies forpolicy formulation even when they are not based onrealistic assessments of the structure of their economies.This leads to wrong policy choices and has consequencesfor the ability of developing countries to meet thedevelopment challenges facing them.

The second potential response is that policy makers maycompletely disregard results and recommendations fromthese studies in policy formulation and base their judgment

on potential realities. While this is understandable, it couldalso lead to wrong policy choices.


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IV. Challenges and Recommendations (Contd)

CGE models have an important role to play in economicpolicy formulation in developing countries. When designedbased on a sound theoretical framework, realisticassumptions and objective choice of parameters, they canprovide policy makers with very useful insights into the

functioning of their economies. Developing countriesshould continue to pay attention to CGE models but theyshould not base policy decisions solely on results ofexisting CGE models since they do not take into accountimportant features of their economies and there is so much

uncertainty surrounding the parameter estimates used forthe simulations.

IV Challenges and Recommendations


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IV. Challenges and Recommendations(Contd)

The credibility of CGE models will improve if modelers

using the CGE methodology adopt and follow simple rules

and principles:

The first is to avoid the temptation to design experimentsand choice of parameters to yield results that justify

predetermined views on trade policy. The second is to exercise caution in the interpretation of

simulation results to avoid sending the wrong message topolicy makers.

Finally, there is the need to have a more transparent way todisseminate results of CGE models. In particular, modelersshould outline the key features of their model that areimportant for the results. This type of transparency willensure that results can be reproduced by other researchers

and make comparisons and interpretation of results mucheasier.


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Thank you for your Attention

the use of models in economic diplomacy

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