Sovereign irresponsibility

There was a fine article by Deborah Hart, the executive director of the Arbitrators' and Mediators' Institute of New Zealand, in Monday's Herald, making the sensible case that the supposedly controversial 'Investor State Dispute Settlement' (ISDS) process within the Trans Pacific Partnership (TPP) is actually a good idea. Read it for yourself: the gist is that ISDS "will work well for NZ" and that "Investor-state dispute settlement is therefore not something to be afraid of. It's part of being a trading nation in a globalised world".

What's baffled me most about the strong opposition to ISDS is the notion that "national sovereignty" is something that is sacrosanct, not to be jeopardised, diminished or traded away. If national sovereignty really trumps everything else, Dachau would still be open, apartheid flourishing, and every Tutsi in Rwanda and every Muslim in Serbia would be dead.

Progressives everywhere ought to welcome international controls on appalling behaviour by "sovereigns" - a useful crutch for the world's kleptocratic tyrants to lean on - as they have since (at least) the founding of the League of Nations in the wake of another fine exercise of national sovereignties, the Great War.

What "sovereigns" are demonstrating when they resist principles-based restraints - when, for example, neither China nor the US will participate in the International Criminal Court - is that they prefer the option of unprincipled behaviour. When countries sign up to the likes of the ICC, or to the ISDS provisions in the TPP, they're saying the opposite: we'll play fair, and we don't mind being judged on it. That's exactly where New Zealand should be.

Another blast from the past

Statistics NZ's Twitter feed just posted this fun item:

It has a link back to a piece that Stats published in 2012, 'Delving into the clothes basket - tracking women's and men's clothing in the CPI', which went back to 1924 to look at what men and women and children wore.

It's fascinating - today's girls will be pleased that they don't have to wear the woollen bloomers of 90 years ago, and today's women will be pleased they don't have to make their own clothes - and it's one of a terrific series of time capsules that Stats have unearthed and published. Last time I wrote about them, in 'The way we live now', I said that this analysis of past CPIs was "almost a complete social history in itself". It's also a great timewaster, so cancel an hour, head to my post, and follow up the links there to the various Stats publications.

For me - and here I stress this is my take, not Stats' view or interpretation - the clothes basket piece fortuitously showed the potential benefits of trade liberalisation. From the late '80s onwards, tariffs and quotas on clothing imports were lowered or abolished. The results were that clothes prices have risen much more slowly than prices more generally (as the first graph below shows) and people have been able to buy much more (as the second one shows).

And the "cost"? - "the number of jobs filled by paid employees in the clothing and knitted product manufacturing industry fell nearly 60 percent – from 9,550 to 4,120". Four million people, give or take, got a large benefit, while 5,500 people, give or take, lost their jobs. And I put "cost" in apostrophes because many - maybe all - of those people will have found other jobs, and in activities that the community values more highly than keeping a small-scale rag trade going.

It's also very likely that liberalising clothing imports was a progressive move (in the tax policy sense of "progressive" as opposed to "regressive"). At home, the household budgets of lower and middle income families, and particularly those with children, will have had one of their bigger costs reduced. And overseas, people in poorer countries will have got real jobs, instead of aid, and started down the road of economic development that will make them better off and, along the way, better customers for our exports. That's a pretty good outcome all round.

A good idea finally gets the nod

First, the good news.

On Thursday Paul Goldsmith, the Minister of Commerce and Consumer Affairs, announced a welcome change to New Zealand's anti-dumping regime. In future, the plan is, domestic producers won't be able to have cheap peaches or tomatoes or building materials shut out of the New Zealand market unless they can show that the damage to them is more than the damage to New Zealand consumers. Which it often won't be: there's only a  few of them, and there's lots of us. A process that has been much abused for protectionist reasons, both here and abroad, is finally getting defanged.

But why has it taken so long?

The Ministry of Business, Innovation and Employment, MBIE, first came up with options for changing the anti-dumping regime in the middle of last year: I wrote about them last July. It was extremely obvious at the time that this new "consumer interest" test was the way to go: as I said, "Free trade often struggles to prevail against producer interests, but even so this should be the easiest, "where do I sign", shoo-in of a policy contest that's ever been run".

Last year rolled by. In December I wondered where the dumping reform had got to: with a number of other small but promising reform proposals, it seemed to have gone to ground within MBIE. Finally, in August, over a year after the obvious way forward had been identified, it gets the tick, though it's still got to go through Parliament. It'll be next year at the earliest before the changes see the light of day.

I understand that there's got to be time allowed for public consultation, and for Ministers to get their colleagues' heads around things. I understand that the legislative hopper can get backlogged. But we like to think we're a small but informal and flexible country, and in any event we need to be if we're going to be internationally competitive. This speed of reform is just too slow.

Overgenerous protection?

I'd never heard of the Express Scripts prescription-price index before I read 'Much ado about something', an article on generic drugs companies in the latest issue of the Economist (it may be available here but it may be paywalled, I can't easily tell as I've got a subscription). The article said that "whereas the average price for branded medications in America has risen by 127% over the past seven years, the average for generics is down by 63% over that period".

I was rather intrigued by this from a competition perspective, so I went to the source. Express Scripts is a US listed company that provides various pharmacy processing and management services, and it has a website, 'The Lab', where it publishes a range of interesting analysis and research. One of its publications is its Drug Trend Report, and on p57 you'll find this graph of the prescription-price index, which measures the prices of the most commonly prescribed drugs in both their branded and generic versions (it's also on p6 of the Executive Summary pdf).

It's hazardous drawing conclusions from one country, and one country with a rather dysfunctional health system at that, but these patterns do lead you to wonder whether patent protection hasn't been overdone. Yes, of course, the costs of developing safe new drugs are high and rising, and patents should enable drugmakers to recover their costs and earn an appropriately risk-adjusted rate of return on their outlays. And yes, you'd have to do the heavy lifting of comparing actual and fair WACCs to be make a fully informed call (and even then there'd be judgement calls involved). But price divergences of this order at a minimum make you wonder whether the length or scope of protection haven't been overdone. Overgenerous protection  would also help explain the squalid trade of branded producers bribing potential generic competitors not to produce (as I wrote about here, here and here).

I'm hesitant even to mention the Trans Pacific Partnership - every anti-trade nutter in the country will be reaching for their tin-foil helmet - and I'm going to reserve final judgement on the thing till I see all of it as a package. But if, as has been widely speculated, one of the elements is extended life for intellectual property protection, then it's probably a step in the wrong direction.

Playing monopoly

Monopoly is in the air. The kiwi fruit people want more of it: the Herald's coverage of their recent industry poll is here - where I learned that the polite word for "monopoly" these days in kiwifruit circles is "single point of entry" - and the meat industry would like some, too.

That's one of the core recommendations in a recent report by Meat Industry Excellence (and I should tip a hat in the direction of John Small's website, where I first saw mention of it). They're a ginger group who describe themselves as "passionate farmers and industry supporters who can clearly see the opportunities (and the barriers to progress) for our red meat sector. They are a diverse group who are prepared to stand up, collaborate and work with farmers and industry to create sustainable profitability for all players".

Fair enough, and actually I have some sympathy for their diagnosis of what ails the meat industry and for their vision of creating and capturing high value add through a focus on the end consumer (though if you can also hear the hoofbeats of a "But" galloping towards us, you're right). Stock numbers have dropped sharply, stranding processing assets, which means that a deadly game of musical chairs is underway. Processors are playing over the odds to get stock through their plant rather than the other fellow's, adding to the financial costs of carrying the surplus capacity, and leaving nothing over to pay for the marketing and innovation that would raise industry incomes all along the value chain (there's an argument that that the processors were never that good at the marketing end even in better times, but that's for another day).

Their suggested ways forward are some combination of industry aggregation (to something like a Fonterra-sized processor), a collective approach to rationalisation of the spare capacity including a cunning plan, 'chain licensing', which would cap capacity, and a collective or coordinated approach to export marketing, perhaps along Zespri lines. That's my potted summary: Rod Oram's got one here, and Lincoln's Agribusiness and Economics Research Unit have a rather longer one here.

What bothers me about this is the strong lean towards monopoly market solutions at the expense of competitive market solutions. It's not universal:  the draft paper on the chain licensing says, for example, that

Competition and choice at the farm gate must remain. Animosity by some processors against competition is misplaced.

Competition is essential for the Industry. It is overcapacity and lower livestock numbers which has led to the low plant utilization within the Industry...Marginal pricing, refusal to close plants because of high redundancy costs, focus on throughput and fixed cost amortization, excessive use of third party buying agents, and adding extra capacity are all competitive responses that are rational within the current structure of so much additional capacity. They result not from the principle of competition but from overcapacity

But otherwise it's pretty much pervasive among those casting around for potential ways forward to reach for Fonterra and/or Zespri as proven models from other industries. Fortunately, some of these ideas are non-starters. Animosities and incompatibilities among the processors likely put the kibosh on all the grander schemes of agglomeration, as would the Commerce Commission, since I don't see the required authorisation as likely to be forthcoming: orchestrated stitch-ups to create monopsony power against suppliers and monopoly power against consumers rarely get the nod, and for good reason. And the chain licensing idea would also need some get of jail free card, as it too looks bang to rights under the Commerce Act. But even if they were enabled through the meat industry equivalent of the legislation that created Fonterra, they look to me to be the wrong approach, for two reasons.

One is that there are, in fact, good working examples of thriving, competition-based, agricultural export industries, with the outstanding example being our own wine industry (and arguably another in the making, in the craft beer trade). And the French wine and cheese trades successfully get their Cotes du Rhone and Roquefort to me using exactly that model of large numbers of French companies competing against each other for the same overseas customers that is supposedly the "problem" that the Zespri route is meant to "solve". So it's by no means a given that Fonterra-style or Zespri-style models beat market models, where competing companies are forced to add value and to innovate to succeed. And  it is worth remembering that the Commerce Commission, when the original Fonterra idea came through their door in 1999 before the thing got its own legislation, found that "the Commission has reached the preliminary view that it cannot be satisfied that the public benefits of the proposed merger are likely to outweigh the competitive detriments".

And the other is that chain of links that goes: create a monopoly, generate more profit, use the money to fund product and market development. You can certainly do the first two, but the third leg looks highly suspect. A monopoly is just about the last organisational form you would expect to be highly consumer-focussed and highly innovative. We've got the magnificent diversity of our premium wine offerings, very largely driven by micro, small and medium-sized companies, all jostling with their ideas in the marketplace: does anyone seriously believe a Wine Export Board would have achieved a tenth of that success?

Comparative Advantage and Trade

We live in a globalized world where virtually all countries interact and engage in trade. Most of them have various trade connections with a multitude of different countries. As a consequence, there is a significant amount of competition. This raises the question how smaller countries with relatively weak economies can still participate and benefit from global trade.

To explain this we will look at the principle of comparative advantage, one of the most basic microeconomic concepts. Even though it is a rather simple concept, it will allow us to analyze some of the most fundamental processes behind production decisions and trade. So let's get started.

Absolute advantage

The principle of absolute advantage builds a foundation for understanding comparative advantage. It is commonly used to compare economic outputs of different countries (or individuals). By looking at the inputs required for producing a unit of output, it is possible to determine which country has the highest productivity. In other words, the country that requires the least inputs to produce one unit of output is most productive and therefore has an absolute advantage. 

To give an example, let's look at two countries (A and B) that both produce cars and bikes. The two countries use the exact same materials, only the makespans for the products are different. In country A it takes 10 hours to assemble a car and 5 hours to build a bike. In country B on the other hand it only takes 8 hours to finish a car and 2 hours to assemble a bike. Hence, country B has an absolute advantage in producing both cars and bikes (see table 1).

Table 1: Absolute advantage

As we can see, this illustration does not provide any information on how these countries can profit from trading with each other. It looks like country B has little incentive to trade, since it is more efficient at producing both cars and bikes. So to see how trade can actually benefit both of them, we shall introduce the concept of comparative advantage.

Comparative Advantage

An important aspect that is omitted if we only look at absolute advantages is the presence of opportunity costs. All countries only have a certain amount of resources available, so they always face trade-offs between the different goods. As we know, these trade-offs are measured in opportunity costs. Thus, the country that faces lower opportunity costs for producing one unit of output is said to have a comparative advantage.

For example, if country A produces a car it has to spend 10 hours that could have been used to work on the bikes. In fact, it could have instead assembled 2 bikes (since it only takes 5 hours to build a bike). Obviously the same goes for producing a bike. The time spent finishing one bike could have alternatively been used to build half a car. If we apply this to country B, we can see that the time spent producing one car could have been used to finish 4 bikes. Meanwhile one bike has an opportunity cost of 0.25 cars. Hence, country A has a comparative advantage in producing cars, while country B has a comparative advantage in producing bikes (see table 2).

Table 2: Comparative advantage

The important thing to note here is that it is impossible for a country to have a comparative advantage in all goods. Because the opportunity costs of one good are the inverse of the costs of the other products, there is always at least one good with relatively high and one with relatively low opportunity costs.

Specialization

The concept of comparative advantage suggests that as long as two countries (or individuals) have different opportunity costs for producing similar goods, they can profit from specialization and trade. If both of them focus on producing the goods with lower opportunity costs, their combined output will increase and all of them will be better off.

Revisiting our example, assume that both countries have 2'000 labor hours available. If they both decided to allocate half of those resources to each product, country A could produce 100 cars and 200 bikes while country B could produce 125 cars and 500 bikes. This would result in an overall output of 925 total units (see table 3). 

Table 3: Outputs without specialization

Now, if country A specializes in the production of cars and country B specializes in the production of bikes (i.e. the respective goods with lower opportunity costs), their outputs will look considerably different. In that case, country A will produce 200 cars and no bikes while country B will still manufacture 25 cars and use the rest of its time to produce 900 bikes. This results in an overall output of 1125 units which equals an increase of 200 units due to specialization (see table 4).

Table 4: Outputs with specialization

Note that country B does not fully specialize in order to be able to maintain its current supply of cars, because country A cannot produce enough for both of them even by specializing. However, in most cases (i.e. if both countries can produce enough goods to maintain at least the current level of consumption) it most efficient for both countries to fully specialize in only one good.

Benefits of Trade

As we have seen in most situations the overall level of output can be increased if countries use specialized production. The additional output can then be traded in a way that benefits all parties involved. However, there is no optimal solution for such trade negotiations, thus the outcome mostly depends on the power structures between the two countries.

Furthermore it should be noted that even though both societies as a whole will be better off due to trade, this may not necessarily hold true for all individuals within the countries. For instance, if country A decided to put all its efforts into producing cars, companies and individuals who produce bikes will be left out and thus be worse off than before. 

Finally, we must be aware that countries produce a wide variety of different goods in reality and there are far more actors involved. As a result the decision making and coordination processes become much more complex. In that sense, the principle of comparative advantage is merely intended to provide a basic understanding of the underlying processes of trade.

In a nutshell

Trade is a global phenomenon that virtually all countries participate in. Even countries that have absolute advantages (i.e. more efficient production processes) in all relevant goods can still profit from trade, as long as they have different opportunity costs. In those cases there is always at least one good in which another country has a comparative advantage (i.e. lower opportunity costs). This is due to the fact that the opportunity costs of one good are the inverse of those of the alternative goods, so it is impossible to have the lowest opportunity costs for all relevant goods. By specializing in goods with lower opportunity costs the countries involved can increase the overall level of production and then split the additional output according to individually conducted trade negotiations.

JFDI, MBIE!

There is a bit of a ruckus going on about the performance of MBIE, the Ministry for Business, Innovation and Employment, based on this report. I'm not interested in the point-scoring argy-bargy, though for what little it's worth I agree with the reviewers who noted (p58) their "impression of highly motivated and capable staff, doing things the hard way because they are struggling both to prioritise their efforts and to see the broader strategic context for their work".

What's irked me a bit is that there are three ideas that have gone into the MBIE hopper and haven't come out yet, even though all of them look good (or even very good), would be easy to implement, and would make the New Zealand economy a more competitive marketplace.

The first one, recommended by our Productivity Commission, and conveniently investigated in detail in an Australian context by the Aussies' Competition Policy Review, is to review s36 of the Commerce Act, the bit that aims at stopping companies with market power from interfering with competition. My conclusion, on reading the Aussie report, was "Save the time and money" on our own reinvention of the wheel at MBIE. "I say we send the Aussie Review members a thank you note and a couple of cases of our best Pinot Noir, declare victory, and go home". I know there are people in MBIE, and elsewhere, who thinks it's a big, complex issue, despite the Aussies having fortuitously solved it for us. It isn't.

The second one, again recommended by our Productivity Commission and also standard practice overseas, is to let the Commerce Commission conduct proactive fossicking ("market studies") into the state of competition. It can already do it in the telecoms market, but not generally. It would take part of a morning to write the amendment to the Commerce Act.

The third one is the state of our anti-dumping regime, which is too easily abused and which allows domestic producers to avoid competition from overseas and to rort the local consumer. In June 2014 MBIE came out with a good paper with three options, one of which clearly outclassed all the others. As I said at the time, "this should be the easiest, "where do I sign", shoo-in of a policy contest that's ever been run". So why hasn't it been?

More evidence of free trade payoffs

Post-election, thoughts have turned - finally - to policy. It's reported in the Herald that among the likely policy initiatives over the next three years, John Key "identified progress on a trade deal with South Korea, which is close to a conclusion, and the Trans Pacific Partnership as priorities".

A bilateral deal with South Korea is definitely a good idea: I know, in an ideal world we've have comprehensive multilateral trade agreements, but it's not an ideal world, and take what you can is the order of the day. These bilateral agreements can be quite handy: our agreement with China, for example, gave us a clear competitive advantage against the Aussies in the dairy trade with China (as I wrote up here).

Whether the TPP ever gets off the ground, and whether it will in fact be a genuine free trade agreement, is anyone's guess. There have been leaks about the negotiations that have raised suspicions of TPP as potentially protectionist of US intellectual property, rather than helping to free up trade, and I've also seen speculation that the Japanese will make sure that any agricultural trade liberalisation in the TPP will get watered down to meaninglessness.

One worry I've got is that a 'bad' TPP will taint the arguments for free trade, which tend to struggle at the best of times against the loud voices of anti-trade ideologues and of formerly protected interests. The voice of the family buying cheaper T-shirts and food tends not to get much of a look in.

So I thought I'd just point to some new research about one of the big free trade deals - NAFTA, the North American Free Trade Agreement of 1994. At the time the usual suspects came out in force against it: you might remember Ross Perot running for President in the US in 1992 on fears of the "giant sucking sound" of American jobs going down the gurgler towards Mexico (and finding nearly 20 million American voters to agree with him).

The latest research comes from the Peterson Institute for International Economics in Washington, "a private, nonprofit institution for rigorous, intellectually open, and honest study and discussion of international economic policy...The Institute is completely nonpartisan". The summary is here and the whole thing (pdf) is here.

How did this contentious agreement work out? Pretty well, as it happens, though one of the lessons is that proponents of freer trade need to be more realistic about the payoffs: it's not just the opponents that can go off the deep end. That said, the benefits were real: look at this.

This shows the initial level of  goods trade between the NAFTA countries (blue), the extra trade that would have happened in any case as the NAFTA economies grew (dark green), and the impact of NAFTA (light green). Trade was basically twice as large as it would have been without NAFTA. That's a bit of a heavy-handed summary on my part,  and the authors are more nuanced, but the guts is that trade got a large boost.

This increased trade in turn fed through into higher incomes everywhere. As the authors say, these higher levels of trade boosted GDP in all the countries involved (I've left out the footnotes):

Ample econometric evidence documents the substantial payoff from expanded two-way trade in goods and services. Through multiple channels, benefits flow both from larger exports and larger imports. As a rough rule of thumb, for advanced nations, like Canada and the United States, an agreement that promotes an additional $1 billion of two-way trade increases GDP by $200 million. For an emerging country, like Mexico, the payoff ratio is higher: An additional $1 billion of two-way trade probably increases GDP by $500 million. Based on these rules of thumb, the United States is $127 billion richer each year thanks to “extra” trade growth, Canada is $50 billion richer, and Mexico is $170 billion richer. For the United States, with a population of 320 million, the pure economic payoff is almost $400 per person. 

The same is true of the proposed agreement with South Korea, as MFAT's briefing page on the negotiations points out:

An independent joint study into the benefits and feasibility of an FTA was completed in 2007. It found that New Zealand and Korea are two of the most complementary economies in the Asia-Pacific region and that an FTA would deliver economic benefits for both countries. The analysis, by the New Zealand Institute for Economic Research and the Korean Institute for International Economic Policy, suggested that the FTA would provide gains to real GDP between 2007 and 2030 of US$4.5 billion for New Zealand and US$5.9 billion for Korea.

Opponents of trade liberalisation, in short, would take US$10 billion of benefits from a Korean agreement alone, and scatter them to the winds.