Date created: 28 November 1996
Last modified: 18 November 1997

Maintained by: John Quiggin
John Quiggin

Be wary of the micro dynamic gains thesis

Australian Financial Review

Jul 8 1994

Much discussion of economic policy is centred on the premise that comprehensive microeconomic reform along free-market lines is both necessary and sufficient for a return to prosperity. The move from a tariff-protected economy to free trade is the paradigm example. Unfortunately, although orthodox neoclassical analysis based on static considerations yields a presumption in favor of tariff reductions and other microeconomic reforms, the estimated benefits are fairly modest. Given that many of the obvious reforms have already taken place, even a relatively optimistic analysis of the allocation benefits of future reform is unlikely to imply net gains in excess of a few per cent of GDP. For example, the welfare benefits associated with eliminating a uniform 5 per cent tariff are equivalent to about a week's worth of economic growth. (Slightly large, but still modest, gains would arise from eliminating the remaining islands of high protection in the motor vehicle and TCF industries).

The more sophisticated supporters of microeconomic reform have tacitly accepted this point and have turned to arguments based on the supposed dynamic benefits of reform. As Judith Sloan observes (AFR, June 30), it is now widely agreed that these dynamic benefits greatly outweigh the static gains from freer trade and other microeconomic reforms. However, this agreement has arisen, not from the force of empirical evidence or from any clear theoretical rationale, but from a combination of persistent repetition and a widespread will to believe.

The dynamic gains thesis, in one form or another, has been incorporated by assumption in most recent estimates of the benefits of microeconomic reform. For example, a paper by EPAC recently estimated that continued microeconomic reform would yield gains of as much as 13 per cent in GDP. However, the bulk of this gain was generated by the method of assumption - it was assumed that micro-economic reform would generate a reduction in the underlying rate of unemployment. Actual experience, both in Australia and in other English-speaking countries, has been that micro-economic reform has coincided with apparently permanent increases in unemployment. The EPAC paper builds on earlier work by the Industry Commission which implied static gains of 3 per cent of GDP. These were turned into dynamic gains of 6 per cent by virtue of assumptions which, in effect, implied that any policy change that benefits the mining sector will generate massive improvements in economic performance. Once again, the empirical support for these assumptions is quite dubious.

Individual pieces of evidence that seem to support the dynamic gains thesis are given much more prominence than they deserve. For example, the rapid growth in exports of elaborately transformed manufactures (the only piece of evidence of dynamism cited by Judith Sloan) has been widely publicised - it even earned a couple of pages in Budget Paper No 1 this year. It is far less widely reported that our total output of elaborately transformed manufactures is actually declining, and that employment in this sector is declining even more rapidly. Increases in imports have more than outweighed the combined effects of growing domestic demand and increasing exports. This is, of course, exactly what a static neoclassical model would predict as a result of reduced protection.

On the other hand, empirical evidence that goes the wrong way is resolutely ignored. For example, financial deregulation led to a doubling of the number of people employed in the financial sector, with no obvious increase in final output - on the face of it, a serious reduction in productivity. Although the massive increase in activity in asset markets was supposed to increase the efficiency with which those assets were used, private-sector productivity performance in the 1980s was miserably bad.

What about the theoretical arguments in favor of dynamic benefits ? In most cases, they represent some version of the notion of X-efficiency - that firms exposed to the bracing atmosphere of competition will respond by eliminating internal inefficiency and seeking out opportunities for innovation. Arguments of this kind are something of a double-edged sword, since they frequently imply that even greater gains could be realised with an appropriately chosen form of intervention.

For example, it is frequently suggested that protection has made Australian firms inward-looking and complacent. It is then suggested that under free trade competition from imports would make firms serving the domestic market 'lean, mean and efficient' while an outward-looking, export-oriented economy would yield dynamic benefits associated with the growth of the Asian region.

The difficulty is that the argument about the benefits of import competition appears to imply that even better results would be obtained if tariffs were replaced by import subsidies, particularly in the case of industries that enjoy 'natural protection' through transport costs, and hence would not normally benefit from the effects of competition. Similarly, the claim that an outward-looking attitude is desirable in itself appears to suggest a strong case for subsidising exports.

None of this implies that microeconomic reform should be abandoned. Even small gains are worth realising. However, the notion that microeconomic reform alone will solve our problems, or that concern with unemployment should be put aside in case it jeopardises the push for reform, should be recognised for the delusion it is. The costs of high unemployment far outweigh any benefits of microeconomic reform. Reform will be worthwhile only if it is developed in the context of a program to restore full employment.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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