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

Outline
I.
II. III.

IV.

Introduction. Why Do Policy Makers Need CGE Models? To What Extent CGE Simulations Can Be Relied On In Developing Countries? Challenges and Recommendations.

I. Introduction

Economic models in general and Computable General Equilibrium (CGE) models specifically are widely used in economic diplomacy, and have formed the basis for policy advice to developing countries on the potential impact of trade liberalization on their economies.

CGE models are computer- based simulations, like laboratory experiments. They compute how todays economy will look like in the future as a consequence of a special set of policy changes. Policy makers can take the simulation results into account as they consider their options.

I. Introduction (Contd)

Various global CGE models have been used for trade

policy analysis, these include for example: the Michigan model of world production and trade; the G- Cubed model; the Global Trade Analysis Project (GTAP) model developed by the center for Global Trade Analysis at Purdue University; and the LINKAGE model of the World Bank.

Clearly, there are differences between these models in

terms of structure, assumptions, database and choice of model parameters.

I. Introduction (Contd)
Most of these models show that: There are global gains from trade liberalization. There are winners and losers as a result of trade liberalization. Whether or not a country derives benefits would depend on the type of goods it imports and exports, and its ability to respond to potential market opportunities to be created by liberalization. More specifically, countries that are net food importers as well as those that face severe supply constraints are likely to incur welfare losses. In models with a high level of aggregation, this effect does not appear in the results, as losses are compensated for by the welfare gains of other countries in the region. Thus it is important to achieve a fine level of regional disaggregation in the simulations to identify the winners and losers from trade liberalization.

I. Introduction (Contd)
There is no doubt that CGE models have contributed to economic policy formulation. However, in recent years they have been subjected to serious criticisms, for example: These models are typically aggregated to a degree that can obscure important underlying relationships; Data are not always of high quality and some data may be missing; Estimates of the responsiveness of supply and demand to price changes are not necessarily accurate; Choices among scenarios and model specifications can imply very different results; Static simulations are likely to miss crucial parts of the story and dynamic simulations are more complex driven than static ones. Most modelers are, of course, well aware of these problems, but the same way may not be true for policy makers.

II. Why Do Policy Makers Need CGE Models?

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 trade liberalization 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 alert him 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.

II. Why Do Policy Makers Need CGE Models? (Contd)

Thus CGE models are valuable as a tool for:

Confirming policy makers insights or validating intuition about the likely effects of a policy;
Alerting policy makers to unanticipated consequences of a policy; Understanding how a policy works its effects through the economy; And developing a global rather than a local perspective about the impact of the policy.

II. Why Do Policy Makers Need CGE Models? (Contd)

While models should complement or improve policy analysis, they are not a substitute for it. Simulation results are necessarily subject to error and the quality of the results will vary with the appropriateness of the model to the problem at hand, the quality and timeliness of the data and parameters chosen. The results of CGE simulations are only as good as the specification of the models and the data that are fed into them. Because information about an economy and the way it will react to changes are never perfect, one can have legitimate reservations about precise model results. Policy makers will need to exercise judgment on how far model results should drive policy making.

II. Why Do Policy Makers Need CGE Models? (Contd) CGE models are recently used in economic diplomacy
especially in developing countries. In fact, the term economic diplomacy is of recent origin as well. Economic diplomacy was earlier known as trade diplomacy. Trade diplomacy came with the nationalization of industries in many countries from the 1950s to the 1970s. This resulted in gradual involvement of diplomats in trade matters that is to sell products of nationalized industries.

Economic diplomacy can be described as formulation

and advancing policies relating to production, movement or exchange of goods, services, labour and investment in other countries.

II. Why Do Policy Makers Need CGE Models? (Contd)

Economic diplomacy is concerned with the prediction of outcomes of future trade regimes and therefore it will need an understanding of market factors at work in a given global economic environment and in that process, a country will involve in making decisions in advancing economic interests. A distinctive feature of economic diplomacy is that private sectors are involved in the decision- making process to influence negotiating position to remain in the global or regional competitive market.

II. Why Do Policy Makers Need CGE Models? (Contd)

Globalization of economy has greatly increased the range and variety of economic diplomacy. The range of countries active in economic diplomacy has expanded and now spans the whole globe. To pursue economic diplomacy presupposes that there must be a pool of skilled persons in the government and private sectors to understand and negotiate key economic issues from national perspective, that explains why do policy makers need to concern themselves with CGE models, simply because the use of models should help improve policy making.

II. Why Do Policy Makers Need CGE Models? (Contd)

Modelers sometimes can be effective partners of policy makers. Economic modeling can provide the necessary analytical support for policy making. Everything else being held equal, those who have numbers normally triumph against those lacking them. And those who have better numbers can expect to succeed more often. While there are indications to show that CGE models are now being more widely used by policy makers around the world, it is more difficult to determine how much all this has improved policy formulation.

III.

To What Extent CGE Simulations Can Be Relied On In Developing Countries?

This section highlights issues that need to be addressed in the 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.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: Most CGE models introduce product differentiation by assuming that imports and domestic goods are imperfect substitutes in demand. This follows the work of Armington (1969) and has the implication that each country is the sole supplier of its products and so can affect the price of the product. Clearly, the assumption that countries are large enough to affect the market price of their exports is different from what we know about developing countries. With the exception of a few products, exports of most developing countries represent only a small fraction of world exports and so they cannot affect the world prices of their exports.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) The Armington model explains international trade as entirely intra- industry trade in differentiated products (how about inter- industry trade in homogenous products?).

The general equilibrium properties of an Armington model are very sensitive to the magnitude of the Armington elasticities. When the value of Armington elasticity turns from greater to smaller than unity, the general equilibrium properties and the behavior of the Armington model change completely.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) Although most CGE models use above- unity Armington elasticities for most industries, low Armington elasticities can still be found in certain industries. These are reasons to believe that the Armington elasticities used in current CGE models may be inconsistent with their database. This is because the magnitude of Armington elasticities is likely to be 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 substitutes in consumption. This requires Armington elasticities to be reasonably large, often well above unity.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) The Armington model tends to produce results that emphasize the exchange gains from trade. The explanation for trade being entirely intra- industry in nationally differentiated goods makes the Armington model incapable of capturing the gains from resource reallocation or comparative advantage.

There is the need for CGE modelers to revisit this assumption to capture more accurately the features of developing countries' economies.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) As we know from economic diplomacy, trade negotiation is a bargaining game and the nature of interactions and the availability of information affect the outcome of the game. Strategic behavior among countries is completely ignored in CGE models. Big countries or groups such as the United States and the European Union are in a better position to influence the negotiations and this has serious implications for developing countries. This issue needs to be taken into account in the use of CGE models in developing countries.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd)

CGE models neglect some forms of market imperfections such as those in credit and factor markets of developing countries that have serious implications for the ability of these countries to take advantage of potential trading opportunities created by trade liberalization and should be taken into account in the modeling exercise. The presumed economic benefits of trade liberalization are unlikely to be realized in developing countries if product markets are liberalized without addressing credit and factor markets imperfections.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd)

One of the key assumptions made in CGE models is that trade 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 total government revenue unchanged after trade liberalization. This is based on the unrealistic assumption that governments can fully recover lost tariff revenue by switching to domestic taxes. Empirical evidence shows that poor countries that adopted trade liberalization failed to recover most of the lost revenue by switching to domestic taxes.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) 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 is problematic because it is inconsistent with empirical evidence.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Theoretical Framework: (Contd) 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 liberalization would 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 exposure to risks, this ought to be taken into account in CGE models, as they will definitely affect welfare changes to developing countries.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
TheDatabase: The availability of high quality and comprehensive data is crucial to CGE analysis. Therefore if the database used for simulation does not accurately capture the current structure of the economies under investigation, it is difficult to have confidence in the results of the analysis.

Due to data limitations in developing countries, some of them are classified into composite groups; this level of aggregation does not recognize the heterogeneity among developing countries and does not permit researchers to measure the impact of trade liberalization at the national level.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Behavioral Parameters:

The behavioral parameters measure the responsiveness of producers and consumers to relative price and income changes and therefore have an important bearing on the outcome of a CGE simulation. One of the important criticisms leveled against CGE models is the quality of the information used to derive these behavioral parameters. In some cases, the CGE modelers do not statistically estimate these parameters themselves but take them from other sources.

III. To What Extent CGE Simulations Can Be Relied On In Developing Countries? (Contd)
The Behavioral Parameters: (Contd)

In other cases they make choices of these parameters based on subjective judgments or take them from econometric estimates obtained using data not related to the period covered by their simulation. While databases may be regularly updated, the estimates of the parameters are not, so some of the behavioral parameters are based on estimates that are about 15 years old and so do not reflect the current structure of the economies under consideration. The high degree of uncertainty surrounding estimates of these key parameters suggests that we should be careful about making strong and unqualified statements regarding the impact of trade liberalization on developing countries.

IV.

Challenges and Recommendations

In recent years, there have been many CGE models that differ in terms of structure and often give different answers to the same questions. This is a source of confusion for policy makers especially in developing countries where there is a lack of adequate analytical capacity to evaluate the results of these models. Several developing countries do not have adequate research capacity to conduct analytical studies on key issues of interest to them and so they often rely on results of research carried out by international institutions and academics.

IV.

Challenges and Recommendations (Contd)

When researchers present results that differ significantly and there is no explanation as to why these discrepancies occur, policy makers find themselves in a very difficult situation because they do not know how seriously to take the results. In particular, they do not know which of the studies is more accurate and relevant to their situation.

Unlike policy makers from developed countries, developing countries policy makers are often not in a position to evaluate these studies to determine how credible and useful they are as bases for policy formulation. This can lead to one of the following unattractive responses by developing countries' policy makers:

IV.

Challenges and Recommendations (Contd)

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

The second potential response is that policy makers may completely disregard results and recommendations from these studies in policy formulation and base their judgment on potential realities. While this is understandable, it could also lead to wrong policy choices.

IV.

Challenges and Recommendations (Contd)

CGE models have an important role to play in economic policy formulation in developing countries. When designed based on a sound theoretical framework, realistic assumptions and objective choice of parameters, they can provide policy makers with very useful insights into the functioning of their economies. Developing countries should continue to pay attention to CGE models but they should not base policy decisions solely on results of existing CGE models since they do not take into account important features of their economies and there is so much uncertainty surrounding the parameter estimates used for the simulations.

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 experiments and 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 to policy makers. Finally, there is the need to have a more transparent way to disseminate results of CGE models. In particular, modelers should outline the key features of their model that are important for the results. This type of transparency will ensure that results can be reproduced by other researchers and make comparisons and interpretation of results much easier.

Thank you for your Attention