An evaluation of the performance of applied general equilibrium models on the impact of NAFTA

This paper evaluates the performance of three of the most prominent multisectoral static applied general equilibrium (GE) models used to predict the impact of the North American Free Trade Agreement (NAFTA). These models drastically underestimated the impact of NAFTA on North American trade. Furthermore, the models failed to capture much of the relative impact on different sectors. Ex post performance evaluations of applied GE models are essential if policymakers are to have confidence in the results produced by these models. Such evaluations also help make applied GE analysis a scientific discipline in which there are well-defined puzzles with clear successes and failures for competing theories. Analyzing sectoral trade data indicates the need for a new theoretical mechanism that generates large increases in trade in product categories with little or no previous trade. To capture changes in macroeconomic aggregates, the models need to be able to capture changes inproductivity. Herbert Scarf's work on the computation of economic equilibrium has transformed the way economists think about putting general equilibrium (GE) theory to use. Previous economists – notably Leontief (1941), Johansen (1960), and Harberger (1962) – had matched simple GE models to data and used these models to answer important economic questions. Scarf's work (1967, 1973) on computation forged the link between applied GE analysis and the theory of general economic equilibrium developed by researchers such as Arrow and Debreu (1954) and McKenzie (1959). Let me give a partial account of and reflections on the development of applied general equilibrium models. This is not a true scholarly account but relies primarily on my own impressions over the years. It originated as an after-dinner speech and should be regarded as a written version of one.