Why the TPP is bad from a neoclassical economic perspective

From now on I’m going to be doing more blog posts about things on which I know quite a lot —enough to correct inaccuracies in some public reporting for example — but not enough to think I should try to post this somewhere fancy. This is the first such post. They are aimed at people who know very little about the topic, so don’t expect much complex analysis or anything.

The trans-pacific partnership (henceforth TPP) is a US led initiative aimed at changing the contours of trade in the Asia Pacific. Given the significance of Asian trade flows, it will undoubtedly have spillover effects globally. Note that I said ‘change’ rather than ‘liberalise’, ‘improve’ or ‘increase’. That was a deliberate choice. The TPP is a bad policy (except maybe for Japan, who desperately need it to drive a domestic reform agenda).

To understand why, we must first talk a bit about the benefits of trade and the history of trade liberalisation. Trade is good for development. The benefits emphasised the most in textbooks arise from comparative advantage—the so-called static gains from trade. Factor endowments (labour skill, wage level, geographic factors, cultural factors etc) determine the comparative advantage of nations. For example, China has a comparative advantage in mid-level manufacturing (toys, low-end electronics) and heavy industry (steel, for example) as a result of its wage level, labour abundance and demand for cheap steel. Australia has a comparative advantage in finance because of its large capital endowment (accentuated by compulsory super) and highly educated workforce, and in coal and iron production because of its large natural endowment of both. If each nation focuses on doing what it is good at and trades they will both achieve higher welfare overall. This can be shown very formally and is substantially empirically validated. I will not go into such detail. Suffice to say that if you think trade is bad on the grounds of efficiency (as opposed to things like quality control and volatility) you are willfully ignorant.

But static gains from trade are not actually the main reason you engage in trade liberalisation, especially if you are a developing country. Rather, the main reason you engage in such reforms is to derive dynamic gains from trade. These include foreign direct investment (firms offshoring and employing your labour), technology transfer (in the form of new products, new business practices and learning by doing), the spread of new ideas (e.g. Buddhism spreading out of India) and, most importantly, competitive pressure. One of the strongest dampeners of growth is vested interests—groups that have captured markets (both labourers and employers can be vested interests) or otherwise benefit from the existing status quo and thus seek to resist change. Openness to trade exposes such groups to foreign firms trying to penetrate their markets. Often these foreign firms bring cheaper, higher quality products, more effective and efficient practices and a greater willingness to experiment and take risks. This dynamism forces both foreign and domestic firms to increase their productivity, driving growth without putting extra stress on resources, labour or capital. Weaker firms exit the market and only highly efficient firms producing relatively good products and relatively low-cost remain. The view that foreign competition harms domestic industry comes under the heading of ‘mercantilism’, and it is one of the most disproven ideas in economics. Again, I’m not going to go into detail here, but perhaps in a future post.

So trade is good for humanity. Unfortunately, it has historically been very difficult to get countries to increase their exposure to trade by lowering tariffs, reducing subsidies to domestic producers, reduce red-tape that affects only foreign firms etc. The reason for this is a classic prisoner’s dilemma. If country and X and Y agree to liberalise their borders they both stand to benefit. But country X believes it will benefit more if it can retain its barriers while Y drops theirs. Hence there is always an incentive to ‘defect’ and maintain your barriers. This prisoner’s dilemma dynamic was conquered in the twentieth century by the World Trade Organisation (WTO), which can legally punish all signed-on members to ensure that it is more beneficial for them to open up than to defect.

The WTO proceeds in rounds of negotiation. Unfortunately, it is currently stalled at the so-called Doha round for development. This is because the Doha round tried to the turn the WTO from an economic vehicle into a political vehicle, but that’s a topic for another post. While the WTO is stalled barriers remain up in some countries and some sectors and progress isn’t being made on so-called ‘21^st century trade issues’ like the liberalisation of service sectors, investment liberalisation and regulations around labour safety and environmental standards.

In the absence of action in the WTO, countries have taken to negotiating agreements directly with each other in bilateral and trilateral trade deals like the Australia–China agreement and the China–South Korea–Japan agreement, as well as some ‘mega-regionals’ like the North American Free Trade Agreement (NAFTA). These do reduce barriers, but preferentially. For example, Australia agrees to reduce its barriers on American enterprises operating in the defence space in Australia provided America reduces its barriers on beef. These benefits are only available to the signatories to the free trade agreement and not to anyone else.

This seems good for the countries involved, but it is bad for global trade flows because it distorts natural comparative advantage. For example, if New Zealand is better at dairy than Australia but the Aus–US free trade agreement (FTA) gives Australia a 5% advantage in the US market that makes it more price-competitive than New-Zealand dairy then Americans will start buying Australian milk. This is inefficient because Australia does not have a comparative advantage in milk. You want people doing what they are best at and slowly expanding into other sectors as their comparative advantages change (as China is now doing in higher tech areas as the skill level of its workforce increases). Moreover, in modern trade where people mostly trade components rather than finished goods, tracking who produced what at the border in order to apply lower to tariffs can quickly turn into an administrative nightmare, driving up transaction costs and wiping out the gains from trade. This is the great tragedy of Asia’s so-called ‘noodle bowl’ of free trade agreements.   

The WTO recognised this dynamic, hence why it insists on multilateral trade liberalisation i.e. everyone at the same time. Those who can’t get on board due to domestic issues, like China in the past, were excluded from the benefits until they met the base requirements, at which point they could accede.

Recently, two projects have emerged to dominate attempts at bringing about multilateral trade liberalisation in Asia: the aforementioned trans-pacific partnership, a US-led initiative, and the Regional Comprehensive Economic Partnership (RCEP), ostensibly a Chinese initiative but with substantial buy-in from ASEAN nations.  The TPP is political poop dressed up as a trade agreement. RCEP perhaps lacks ambition but is otherwise a step in the right direction. Let’s investigate why.

The TPP is not actually a multilateral agreement at all. In fact, it is a collection of bilateral agreements mixed into one big agreement. This is crap, as we’ve discussed.

The TPP is the flagship policy in the US State Department’s Asia pivot and quite clearly aims to contain China’s rise. Notably, clauses in the TPP around state ownership of firms, among other things, exclude China from the agreement. This leads to the policy being terrible on a range of fronts. Most critically, China will be excluded from the Asian trade dynamics of which it is currently the centre. Rather than doing business with China, Asian nations will instead engage in deals with less efficient (comparatively un-advantageous) partners because of preferential deals leading to huge dead weight losses across the region.

In exchange, nations will get a stronger US presence in the region. Historically, this has undeniably been a good thing. But outside of the Spratleys and the nine-dashed line more generally, there is no reason at present to suspect that China isn’t committed to maintaining open sea lanes of trade and communication and otherwise being a good major power in the region. It’s initiatives like RCEP, the belt and road, the FTAAP and its carbon markets are substantially more cooperative, mature and benevolent than current US actions in the region. What’s more, the extent to which the TPP obligates the US to maintain a security presence in Asia is unclear, and comes at massive cost. To provide some idea of what the dead weight losses from the TPP might amount to in terms of security we can look at the outcomes of the US-Australia FTA. The US-Aus FTA, which was this dynamic of small nations trading big trade concessions to the US in exchange for vague security in the form of an enhanced relationship, played out in miniature a decade ago, has thus far been estimated to have cost Australia $80 billion dollars. That happens to be the cost of those submarines we want to buy. What’s more of a concrete security enhancement?

The TPP continues a long running trend in US trade negotiation where they leverage their security and strategic assets to extricate economic concessions from smaller nations. The US is incapable of separating its trade strategy from its grand strategy, and cares little for the welfare costs to the region provided its primacy and hence its relatively first position is maintained.

Some say that this is all irrelevant to Australia because the gains for us from the TPP are large and so we should get on board. This is narrow and short sighted. Certainly access to lush US beef and dairy markets, among other things, will be beneficial. But under the TPP we will go from existing in the world’s most dynamic, integrated, liberal and fast growing region into one that is sclerotic, inefficient, burdened by red tape and bureaucracy and threatened by an increasingly isolated, frustrated and hurt China. This will be very costly to Australia in the long run, much more costly than a few billion dollars of beef exports in the next decade or two. Our long term economic prospects are dependent on a region characterised by free exchange. To sacrifice such an environment for the sake of a handful of industries is to voluntarily become a banana republic.

There are two other big problems with the TPP worth discussing – the intellectual property law components and the negotiating paradigm.

The US is quite vocal about the fact that the TPP would see US intellectual property law enshrined across the region. The US always sells this as a good thing because, as economics tells us, intellectual property protection (patents) is required to incentivise innovation. If entrepreneurs can’t be certain that they will have the exclusive right to make money off their inventions then they are likely to feel uncertain about their chances of recovering their R&D costs and research will stall. There is strong historical evidence for the claim that patents set off an innovation explosion in Europe in the Victorian period. What the US fails to mention though is that economics has produced some rather good estimates of optimal patent length. When a patent lasts a long time – long after the technology has become largely redundant – it no longer acts as a catalyst for innovation and instead acts as a drag by driving up transaction costs. Imagine if every time someone wrote a computer program they had to pay the Alan Turing family trust a sum, and the MS-Dos family trust, and IBM and so and so forth. Innovation would quickly become prohibitively expensive. Optimal patent length is currently estimated at somewhere around 7 years. Do you know how long US patents last? 70 years! The TPP is essentially an opportunity for the US to lock the rest of the world into using its products into the distant future. Not cool.

We turn now to the negotiating paradigm itself. This is the traditional approach to trade liberalisation where countries try to cannily offer each other concessions in exchange for other concessions. It is typically mandated by domestic lobby groups but is really expensive, time consuming and, critically at the present juncture, unsuitable for 21^st century trade issues. The only place where such a framework of bartering off tariff reductions could still net large returns is agriculture, and the restraints there are all domestic political in nature. The areas where huge gains could be made very quickly are service sector liberalisation, which mostly about reducing red tape in the form of guild fees (things like certified practicing accountant accreditation for major international firms), investment liberalisation, which is mostly about transparency in the approvals process, and infrastructure development (notably ports, highways and bridges), which is positive sum and thus requires little in the way of negotiation. In none of these areas is the negotiating paradigm appropriate, especially a secret negotiation paradigm. It is unsurprising that diplomatic fora, notably APEC, the belt and road and the Asian Infrastructure Investment Bank, have been the major drivers of developments in these areas in recent times. The negotiating paradigm is yet another reflection of the fact that the US’ interests here are pressing blood from a stone and trying to give the region a raw deal. Only an agreement with winners and losers needs to be negotiated in secret. There’s also the insidious influence of the US corporate lobby, but we’ll leave that can of worms because I don’t have enough info.

I hope I’ve convinced you that the TPP is a bad idea for Asia, and that the Australian public should hold its government accountable for actions they take in the negotiation. Penny Wong gave perhaps the best speech in Senate history calling for more information from the government on its stance in the negotiations. I want to see more of that. In the meantime, let’s keep our fingers crossed that the US lobby groups are so greedy that they will stall the relevant legislation in Congress long enough for the RCEP to conclude and make the TPP so redundant as so fail.

I’ll try to write on RCEP at a later date.