Theoretical framework

The theoretical framework of this thesis is based on the theory of economic interdependence and conflict and the computable general equilibrium modelling.

1.5.1. Theory of economic interdependence and conflict

The relationship between economic interdependence and conflict has been subject to a heated debate in the field of political economy. There are two distinct schools of thought in the debate. The first group, considered as the liberals, maintains that economic interdependence brings peace. The second group, considered as the realists, argues that trade increases conflict between the trading partners.

The liberal proposition is associated with Kant’s philosophy of a perpetual peace that is the result of economic interdependence, expansion of democratic institutions, and joint commitment to the international law and institutions (Oneal and Russett, 2015). The liberals advance the theoretical argument that mutual dependence established between two trading partners (dyads) generates economic benefits for both parties, and that the anticipation of a loss in the welfare gains reduces the willingness of both sides to fight (Hegre et al., 2010). Implicitly, liberals assume that the opportunity costs of the forgone trade are sufficiently high to prevent nations to engage in conflict with trading partners (Polachek and Xiang, 2010). They also infer that trade relations provide both parties with instruments to make costly signals in order to avert militarised conflicts (Heilmann, 2016).

The realist argument postulates that economic interdependence can be used as an instrument of coercion (Stein, 2003). Accordingly, the trading relationship entails costs that may result in conflicts. The costs are especially disproportionate for the more dependent partner, since the less dependent partner may be tempted to use economic coercion to exploit the other party’s vulnerabilities and hence influence its behaviour on economic and security issues (Barbieri and Levy, 1999). Dependency on trade partners for the provision of strategic goods may trigger aggressive expansionist policies to guarantee access to resources and markets, increasing the likelihood of conflicts (Reuveny, 2000). The pursuit of relative gains, i.e. benefitting more from trade than a partner, also causes frictions between countries and leads to trade disputes and trade wars (Souva and Prins, 2006).

8 From this discussion it appears that there is no general conclusion on the effect trade has on conflict (Dorussen, 2006). Trade has both a pacifying and generating effect on conflict. At least three factors determine the direction of the trade effect on conflict. The first factor is whether the trade relation is symmetrical or not. Symmetrical ties may promote peace, while asymmetrical dependence fuels conflicts (Barbieri and Schneider, 1999). The second factor is the distance between the two partners. As demonstrated by Chang et al. (2004), the more the geographical distance between trading partners, the less the likelihood of conflicts. The third factor is related to the cost of finding alternative markets (Goenner, 2010). If finding alternative markets does not come at a high cost for importers and exporters, then the deterrent effect of trade on conflict is small. In contrast, if trade between a pair of partners is highly specific, the deterrent effect of trade on conflict is reinforced.

Another proposition to analyse the relations between trade and conflict is to separate conflict initiation from conflict escalation. Morrow (1999) showed that the trade effect on conflict initiation is mixed because trade relationships generate both gains and issues for debate. However, trade reduces the likelihood for conflict escalation, as it provides the actors with instruments to make costly signals and ultimately reach a peaceful settlement. For their most part, the above-mentioned arguments have focused on the impact of trade on conflict. However, there are concerns that unidirectional models of trade-conflict relationships are miss-specified because trade is not an exogenous variable (Stein, 2003). In fact, the intensity of trade reflects a certain level of inter-state cooperation, as intergovernmental agreements are a pre-requisite for official trade. Moreover, trade can be restricted between partners as part of a strategic signalling (Gartzke et al., 2001). This intertwined link between trade and conflict has led scholars to apply the Granger causality analysis and simultaneous equation systems to disentangle the trade effect on conflict and the conflict effect on trade. However, the results of empirical studies that make both trade and conflict endogenous diverge. Some studies found a statistically significant pacifying effect of trade (e.g. Oneal, 2003; Hegre et al., 2010), while others found either no effect or a conflict-generating effect of trade (Kim and Rousseau, 2005). Other studies reported either a statistically insignificant effect of trade on conflict (Keshk et al., 2004) or mixed effects (Goenner, 2010; Reuveny and Kang, 1998).

The diverging empirical results, though using in some cases the same data sources, is possibly explained by the omission of different fundamental elements of the overall trade and conflict picture (Reuveny, 2000). The validity of the theoretical assumptions that guide the empirical research is also at stake. Subsequently, there is a need for analyses at a more disaggregated level to incorporate differences in terms of commodity group, as well as isolating import and export data, instead of pooling the two into total trade (Dorussen, 2006). Studies should also look at individual dyads instead of pooling all dyads together because the relationship between trade and conflict is dyad-dependent.

9 Most of the discussions on trade and conflict have also embedded the unitary-actor view of the state (Stein, 2003). However, it is clear that trade is carried out by firms and reflects the societal supply and demand conditions, while conflict is an inter-state phenomenon. Therefore, it is important to disjoint the units of analysis. Finally the economic relations between states are not limited to trade in goods and services as pointed out by Souva and Prins (2006) and Gartzke et al. (2001). The bilateral flow of capital and labour should be incorporated in the analysis.

While the empirical results on trade effect on conflict are still puzzling, there is a wide consensus that conflict reduces trade (Heilmann, 2016; Long, 2008; Kim and Rousseau, 2005; Keshk et al., 2004). Although liberal and realist theories disagree about the effect of trade on conflict, they appear to agree that conflict has a negative effect on trade (Reuveny, 2000). Along with this consensus, this thesis investigates the economic consequences of political conflict. The thesis makes an empirical contribution to the understanding of the relations between economic interdependence and conflict using a single dyad composed of Israel and Palestine. The thesis does not limit itself to the relations between conflict and trade of goods and services. Instead, it assesses the economy-wide effects of changes in the conflict-related restrictions on labour movements and trade of goods and services on the Palestinian economy. It makes use of a highly disaggregated database, in which firms and households, who make production and consumption decisions are explicitly separated from the government. The framework to conduct the empirical analysis is the computable general equilibrium (CGE) model.

1.5.2. Computable general equilibrium modelling

The concept of economic equilibrium at the heart of the CGE model refers to a state of balance between opposed forces acting upon the economic variables (Miller and Blair, 2009). Following the neoclassical theory of supply and demand, prices are assumed to clear all markets simultaneously. The economic agents are assumed to be rational. Households maximise their utility subject to a budget constraint, while firms maximise their profits subject to specific production costs and limited resources (Bacchetta et al., 2012). The CGE model recognises that events taking place in one sector of the economy may affect other sectors, which could feedback into the original market through the price mechanisms. When the economy is affected by an exogenous shock, a new set of prices is obtained, which in turn determines production, consumption, employment and income levels.

The CGE model makes use of elaborated behavioural and technical relationships between the variables to capture all relevant linkages between the different sectors of the economy. The principle of accounting identities that underpins CGE models ensures that expenditures

10 do not exceed incomes. Subsequently, the CGE model gets rid of “free lunches”. These features of the CGE model make it well suitable for the assessment of a policy change on the performance and structure of the whole economy (Arndt et al., 2012). Moreover, the way equilibrium prices are set relies on the economic theory, which makes the CGE model appealing for welfare analysis. Two theorems of welfare economics provide the background for capturing welfare effects in the CGE model (Cardenete et al., 2017). The first is that any Walrasian allocation is a Pareto efficient allocation.

The Walrasian equilibrium implies that prices drive the allocation of resources and clear all markets. The Walrasian equilibrium corresponds to an allocation that lies on the contract curve, representing a subset of Pareto efficient allocations, where all the agents do at least as well as in their initial endowments. The second theorem is that a Pareto efficient allocation can be implemented as a Walrasian allocation with the use of lump-sum transfers from the winners to the losers. Following the second theorem, considerations of equity and efficiency can be separated, since the same efficiency level can be achieved with different allocations. The welfare measures that are widely used in a CGE model are the Hicksian compensating and equivalent variations. Using these measures is attractive since they are expressed in monetary units, making them intuitively comprehensible (Bacchetta et al., 2012). Hence, they can be used for interpersonal comparisons of welfare.