Briefing Research paper

The NAFTA Model

Table 13.2 does not single out trade flows between the three NAFTA countries.

Nevertheless, United States trade with Mexico and Canada, is a very large and

important part of the country’s overall trade, constituting 27 percent of U.S. exports

and 24 percent of imports. Given NAFTA’s importance, both in terms of the volume

of trade and as a model that set the pattern for subsequent trade agreements, it is

useful to look at it in more detail. We begin with some background on Canada and

Mexico.

Evaluate the relative importance of the North American Free Trade

Agreement, both for what it accomplished and as a model for subsequent

agreements.

LO 13.2

Explain when purchasing power parity estimates of income per person

are superior to the alternatives, and when they are inferior.

LO 13.3

State the reasons why Mexico and Canada sought free trade with the

United States.

LO 13.4

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Demographic and Economic Characteristics of North America

Table 13.3 gives an idea of the size of the NAFTA region. Income per capita is

measured in two ways: in U.S. dollars converted from Canadian dollars and

Mexican pesos at market exchange rates, and in dollars measured in terms of

purchasing power parity (PPP) . The PPP adjustment enables us to know internal

purchasing power, which is defined as the amount an average income can buy

inside the country where the income is earned when it is measured in terms of the

cost of a similar basket in the United States. Income per capita at market exchange

rates is the external purchasing power of an average income. The differences

between internal and external purchasing power are more easily understood with an

example. Looking at Table 13.3 , an average Mexican income can buy goods and

services in Mexico that would have a value of $17,534 in the United States. This is

the internal purchasing power of an average Mexican income. The external

purchasing power is $9,009, which is the value of the goods and services an average

income can buy if it is spent in the United States. The numbers tell us that on

average, goods and services cost more in the United States than in Mexico. The PPP

concept adjusts for that fact and lets us make international comparisons of income

based on similarly priced baskets of goods and services.

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Table 13.3 Population and GDP for the NAFTA Region, 2015

Country Population

(Millions)

GDP (US$,

Billions)

GDP per

Capita (US$)

GDP per

Capita (PPP)

Canada    35.8   1,552.4 43,332 45,553

Mexico  127.0   1,144.3  9,009 17,534

United

States

321.6 17,947.0 55,805 55,805

Total 484.4 20,643.7 42,614 45,013

The NAFTA market is more than 484 million people and over 20.6 trillion in GDP.

Source: Data from International Monetary Fund, © James Gerber.

The PPP adjustment is necessary in order to compare actual living standards, while

the market exchange rates income is useful to know something about the ability of

people to buy goods and services in the world economy. The two numbers are not

equal because exchange rates are rarely in long-run equilibrium and because non-

traded goods vary in price across national boundaries. For example, labor-intensive

goods and services are inherently less expensive in Mexico where there is a

relatively abundant supply of unskilled and semi-skilled labor.

As shown in Table 13.3 , the NAFTA region has more than 484 million people

(2015) and over $20 trillion in combined GDP. This makes it slightly smaller in

population than the 28 nations and 507 million people that make up the EU, and

slightly larger than the EU’s estimated 2015 combined GDP of US $16.2 trillion.

With an average NAFTA-region GDP per capita (at market exchange rates) of over

$42,000, it is a wealthy region by any standard.

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Canada–U.S. Trade Relations

The United States and Canada have the largest bilateral trade relationship of any

two countries in the world, with two-way merchandise goods and services trade in

2015 of more than $671 billion. This large sum is due to a shared border, a common

historical background, and a similar culture, but it is also the result of three stages of

integration over the last four and one-half decades. Beginning with the Auto Pact

of 1965, followed by the Canada-U.S. Free Trade Agreement (CUSTA) in 1989,

and the NAFTA agreement in 1994, Canada and the United States have taken

advantage of their proximity to foster a set of mutually beneficial trade ties that

focus on natural resources and intra-industry trade, particularly in the auto sector.

The Auto Pact of 1965 removed barriers to trade that previously forced the major

U.S. firms to set up separate plants in Canada where they were unable to capture

the full economies of scale essential to the car industry. By combining their

production in the United States with their Canadian plants, General Motors,

Chrysler, and Ford were able to produce for a single combined market. Before the

agreement, Canadian plants produced solely for the Canadian market; after the

agreement was implemented, they were suddenly more productive, as they could

specialize in particular car models and increase their production runs to serve both

the United States and the Canadian markets. Trade in both directions increased

substantially, and productivity levels in Canadian plants, which were 30 percent

below U.S. levels, rose dramatically.

By the 1980s, the car industry was integrated, but several new problems became

apparent. Both the United States and Canada began to feel the rise of emerging

markets in Asia, and Japan’s inroads into the U.S. auto market, steel, and consumer

electronics were troubling as this seemed to indicate a loss of competitiveness in

many U.S. and Canadian firms. Furthermore, the United States began to use

antidumping and countervailing duties more often along with a new set of quotas

administered under voluntary export restraint (VER) agreements. The latter were

not voluntary in practice but worked the same as quotas in limiting foreign imports

to a set level. The most important affected industry was the Japanese car market.

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From the perspective of Canada’s leadership, growing U.S. protectionism and rising

Asian manufacturing competitiveness were troubling signs because Canada is very

dependent on the United States as an export market and as a source of imports. One

solution to these pressures was to create FTA with the United States. This solution

locked the United States into an international agreement that required it to keep its

market open and, at the same time, put pressure on Canadian manufacturers to

make changes to become more competitive.

The CUSTA was ratified in 1988 and implemented in 1989. CUSTA’s impacts were

more or less as expected. Between 1989 and 1994, Canadian exports to the United

States grew 55 percent ($47 billion increase), while U.S. exports to Canada grew

46.6 percent ($36.5 billion increase). In percentage terms this growth is not quite as

rapid as the period before and after the implementation of the Auto Pact, but given

that trade was already at a high level in 1987, a 50 percent increase represents an

enormous volume of trade.

The debate over U.S.–Canadian free trade was low key and dispassionate in the

United States. In Canada, however, a heated public discussion erupted when it was

announced that the United States and Canada were negotiating an agreement. The

opponents of the trade agreement feared that (1) Canada might not be able to

compete with U.S. firms, which had the advantages of economies of scale; (2)

expanded trade might force Canada to jettison many of its social programs; and (3)

Canadian culture might come to be dominated by the U.S. news, information, arts,

and entertainment industries.

The issue of Canadian competitiveness was largely one about the need to gain

economies of scale and to increase productivity through organizational or

technological changes within firms. For the most part, the real issue for a high-

income, industrialized country such as Canada is the length of time over which the

changes can be expected to occur, and not whether firms are capable of competing.

The Canadian opponents of CUSTA also argued that it would erode Canada’s social

programs. For many citizens, Canada’s more extensive social programs, such as

universal health care and more developed income maintenance programs, are part

of a national identity that make Canada unlike the United States. The opponents of

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CUSTA argued that the intensification of competition with the United States would

undermine these social programs and dilute the difference between the two

countries. They reasoned that social programs would be cut in order to reduce

business taxes and make Canadian firms more competitive. Given that taxes are one

component of business costs, and that in some cases, there are offsetting reductions

in cost elsewhere, and it was incorrect to view a trade agreement with the United

States as a threat to social programs. In the case of health care, for example, it makes

more sense to argue that the United States’ system is at a competitive disadvantage,

because the cost of hiring workers is raised when they must be provided with health

care benefits by their employer. In Canada, by contrast, health care coverage is

universal and is paid for out of general government revenues and individual taxes.

The final and most contentious issue from the Canadian point of view was the

possibility of U.S. cultural domination. A very wide spectrum of opinion, including

both opponents and proponents of expanded free trade, argues that the

combination of Canada’s smaller population and its proximity to the United States

will destroy its national identity if it allows completely free trade in the cultural

industries. These industries include music in all of its venues, as well as radio,

television, newspapers, publishing, magazines, drama, cinema, and painting. Under

the rules of CUSTA, Canada is allowed to protect its national identity by imposing

quantitative restrictions on imports of “cultural products.” In most cases, the rules

allow Canada to impose domestic content requirements on television, radio, and

theater. For example, the content requirements make it illegal for a radio or TV

station to play content originating in the United States twenty-four hours a day.

Cable TV companies give preferences to Canadian-based TV networks, and there

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Mexican Economic Reforms

From the 1950s until the onset of a crisis in 1982, Mexican per capita growth

averaged 3.3 percent per year in real terms, an impressive record that doubled living

standards approximately every generation. This long boom in Mexico’s growth

occurred under a set of trade policies called import substitution industrialization

(ISI) that target the development of manufacturing through support for industries

that produce goods that substitute for imports. As the leading economic

development strategy throughout much of the world from the end of World War II

until the mid-1980s, ISI policies prescribed industrial policies for goods production,

beginning with simple consumer goods such as food and beverage, textiles and

apparel, furniture, and footwear; and advancing through more complex consumer

goods such as household appliances; and into industrial goods such as generators,

pumps, and conveyors. This was to be followed by the development of more

sophisticated industrial goods as countries moved up the ladder of comparative

advantage, gaining manufacturing experience and changing their endowment of

capital and labor skills. The tools employed by ISI policy included industrial support

policies of tax breaks, low-interest loans, subsidies, occasional nationalization, and

high protectionist barriers.

A major weakness of ISI policies is that they discriminate against exports. They do

this by raising the rate of return for firms that produce for the domestic market

where they have high protectionist walls and can charge higher prices while facing

little or no competition. This also hurt Mexico and other ISI economies in the long

run because it reduced the incentive to innovate or make product improvements,

given that there was limited competition. With higher rates of return in the

production of import substitutes, labor and capital were drawn out of the export

sectors and into production for the domestic market. Consequently, when a decade

of poor macroeconomic management in the 1970s came to a head in the 1980s,

Mexico found itself deeply in debt and with limited capacity to export.

The debt crisis that began in Mexico in August 1982 was the result of a series of

factors. From Mexico, the debt crisis quickly spread to the rest of Latin America,

where similar policies had resulted in poor macroeconomic management and the

accumulation of a large amount of debt. This period came to be known as the Lost

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Decade and is discussed in more detail in Chapter 16 on Latin America. In

Mexico, as in most countries, the underlying causes of the debt crisis were heavy

borrowing from foreign banks, weak tax systems, and rising world interest rates that

made debt service more expensive. Mexico had discovered new oil fields in the

1970s, and borrowing was encouraged by the belief that the price of oil would rise

forever and along with it, the country’s ability to service ever-increasing amounts of

debt. When oil prices began to fall in the early 1980s, the Mexican government’s oil

revenue began to decline, just as its interest payments on the money it had

borrowed were going up. These factors were intensified in their impacts on the

Mexican economy by the fact that several decades of ISI policies had weakened the

export sector (other than oil, which received special treatment). Weak export

performance reduced the capacity to earn dollars that might be used to make

payments on foreign debt. By August 1982, Mexico had exhausted its reserves of

foreign currency and could no longer pay its debts. This triggered the onset of the

debt crisis, which ultimately dragged on from 1982 until 1989.

The solution to the debt crisis required multiple policy changes. In the 1980s,

Mexico privatized many firms that had been drains on the federal budget (938 were

privatized between 1982 and 1992), brought its federal budget under control,

reduced its restrictions on foreign direct investment in the country, and began to

open its market to greater competition. In 1986, Mexico joined the GATT and in

1989, President Carlos Salinas proposed an FTA with the United States. Salinas had

two goals in mind. First, he wanted to solidify his reforms in an international

agreement. Before the political reforms that occurred in the late 1990s, Mexican

presidents were granted extensive autonomy and authority. A more protectionist

president could very well overturn the reforms that he and his predecessor (Miguel

de la Madrid) had implemented; but if they were embedded in an international

agreement, it would be much harder. Second, Salinas wanted to attract more foreign

capital to increase the low domestic savings in Mexico. More foreign investment in

Mexico would spur growth, while greater access to the large U.S. market would be

an incentive for investors to build manufacturing plants in Mexico.

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The North American Free Trade Agreement

NAFTA was ratified in 1993 and took effect on January 1, 1994. Trade flows

increased significantly, but they had been growing before implementation, partly in

anticipation of an agreement.

The first important feature of NAFTA is that most forms of trade barriers came

down. Because the United States and Canada were relatively open economies with

few trade barriers, most of the change came on the Mexican side. For example,

between 1993 and 1996, average U.S. tariffs on Mexican goods fell from 2.07 to 0.65

percent. By contrast, Mexican tariffs on U.S. goods fell from 10 to 2.9 percent. These

reductions in tariffs under NAFTA were a continuation of the reduction in trade

barriers that began in the mid-1980s. Between 1982 and 1992, the percentage of

Mexico’s imports that required import licenses from the government declined from

100 to 11 percent, and tariffs fell from an average level of 27 to 13.1 percent. By

1994, Mexico’s economy was substantially open to the world.

Some tariffs and investment restrictions on each country’s cross border investment

were eliminated immediately, but in many cases there was a variable period of

phasing out tariffs and investment restrictions. The phase-out period for these

remaining tariffs and investment restrictions varied from sector to sector. In cases

where there was expected to be significant new competition, industries were given a

longer period to prepare themselves because each country wants to avoid a sudden

disruption of its economy even as it wants gains from trade.

A second feature of NAFTA is that it specifies North American content requirements

for goods subject to free trade. To qualify for free trade or the reduced tariff

provisions of the agreement, a specified percentage (usually 50 percent) of the value

of the good must be made in North America. The purpose of local content

requirements is to prevent non-NAFTA countries from using low tariffs in one

NAFTA country to gain access to all three. Most trade economists dislike these

provisions because they increase the likelihood of trade diversion. Production of

inputs in lower-cost, nonmember countries could be reduced if firms move their

operations to NAFTA countries in order to meet the content requirements—as

happened in the apparel industry, for example. Firms moved from the Caribbean to

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Mexico, even though Mexico was not the lowest-cost producer. Mexico’s exports to

the United States paid zero tariffs, so goods produced there could sell for less than

goods produced in lower-cost countries and subject to high tariffs when entering the

United States. Nevertheless, content requirements were politically necessary in

order to pass the agreement in Canada and the United States.

A third feature of NAFTA is that it set up three separate dispute resolution

mechanisms, depending on the source of the disagreement. Individual chapters

cover disputes related to dumping and anti-dumping duties; treatment of foreign

investors by national policies, called investor-state disputes ; and a third dispute

resolution mechanism for general disputes. Each of these areas is separate from the

consultation mechanisms for disputes over labor and environmental standards,

which are a fourth significant feature of the agreement. NAFTA itself did not contain

language regarding labor and environmental standards or concerns, but two side

agreements were ratified and implemented at the same time as the trade agreement.

These are the North American Agreement on Labor Cooperation and the North

American Agreement on Environmental Cooperation . The labor and

environmental side agreements, along with the investor-state dispute resolution

mechanism, have served as frameworks for most of the subsequent FTAs negotiated

by the United States. Each of these has its supporters and its detractors and will be

considered in more detail in the following discussion of the new trade agreements

signed by the United States.

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Two NAFTA-Specific Issues

A number of highly contentious issues arose during the NAFTA debate, as alluded

to in the previous section. Some of the issues are specific to NAFTA, and some apply

to all or nearly all trade agreements. Labor and environmental standards, relations

between foreign investors and national governments, and intellectual property

rights enforcement are general controversies, but they are also issues where NAFTA

has served as a model for the design of trade agreements with other nations (Table

13.2 ). These issues are discussed later in the chapter. Two specific issues that pose

significant barriers to NAFTA’s deepening are immigration and the ongoing drug

violence in Mexico.

NAFTA did not provide any guidance on immigration policy. Because it is a free

trade area and not a common market, there is no provision for the movement of

labor, except some categories of business people, nor is there any discussion of such

a provision. In most contexts, a free trade area without immigration provisions is the

norm, but in the context of U.S.–Mexico relations, it is a problem. Over the last four

decades, the flow from Mexico has been the largest wave of immigration from a

single country to the United States in U.S. history. Mexican migrants in the United

States numbered more than 11.7 million in 2014 and were 28 percent of all

immigrants. Researchers estimate that just over one-half of the Mexican immigrant

population is unauthorized to be in the United States. Migrants go to the United

States for the usual reasons: jobs, income, and family reunification. They also leave

Mexico for the United States for specific reasons: proximity, the 2,000-mile-long

border that is impossible to close completely, and a lack of jobs and opportunity in

their home country.

The unprecedented wave of migration has declined dramatically in recent years, as

more Mexicans leave the United States than arrive. This trend began around 2005 or

2006 and has at least three factors behind it. One, the border has become harder

and more dangerous to cross. Much of it is desert wilderness with extremely rugged

conditions that are made more severe by the growth of drug violence and the

targeting of migrants by criminal gangs and drug cartels. Two, the political and

economic environment of the United States is more difficult. Jobs are harder to find

since the recession of 2007–2009, and throughout the border region, anti-immigrant

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groups and politicians have created an aggressively unwelcoming political

environment. Three, and most significant for the long term, the demography of

Mexico is changing in ways that are reducing the number of potential migrants. In

1960, the average Mexican woman could expect to have 7.3 children during her

lifetime. By 2009, the number had fallen to 2.4, barely above population

replacement levels. The decline in childbirths leads, with a lag, to a decline in the

growth rate of the young adult population and the number of potential migrants. In

sum, between 2005 and 2010, the number of people born in Mexico and living in the

United States did not increase, as new entrants fell to the same level as the number

leaving the country.

A second issue of grave concern in the NAFTA region is the rise in drug violence in

Mexico. This is a very contentious and tragic issue with no consensus on needed

policy changes, but with a continuing loss of life, mostly in Mexico and mostly

related to the violence of transporting and selling illegal drugs. This issue has far

more than trade implications because it concerns law enforcement, medicine, public

health, economic well-being, civil liberties, and other areas. Currently and for many

years past, both in Mexico and the United States, the discourse is dominated by

politics. In 1969, President Nixon declared a “national war on drugs,” and nearly fifty

years later, similar policies are in place, even as it is hard to show positive results

from the war and as many tens of thousands of people have been murdered as a

result of drug-related violence.

The violence in Mexico is a shared responsibility of the United States and Mexico

because U.S. demand for illegal drugs generates the enormous profits for drug

cartels that are used to corrupt Mexican judges, politicians, and police forces. There

is no consensus on the solution to this dilemma. Classical arguments for legalization

assert that making drugs illegal only forces them underground, where they are still

available and provide profits to organized crime and incentives to use violence to

settle disputes. Legalization proponents point to the problems of corruption, health

and safety issues, and challenges to civil liberties as additional negative spillovers

from the attempts by the authorities to enforce the laws. Counter-arguments are

that addiction is likely to increase if drugs become more available or that it is

immoral to condone drug usage by making it legal. While there is very little

agreement, politicians in Mexico and the rest of Latin America are beginning to

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vocally challenge the U.S. lead in the war on drugs and have begun calling for new

strategies—particularly ones that focus on demand reduction and the public health

aspects of drugs instead of focusing solely on supply elimination.

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Case Study Ejidos, Agriculture, and NAFTA in Mexico

The majority of Mexico’s farmers work on a type of collective farm called

ejidos. Ejido members can farm their individual pieces of land as

independent farmers, planting whatever crops they choose, and their

children can inherit the land, but they cannot sell the land and they cannot

rent it out to someone else. In theory, they either farm it or lose it. The first

ejidos were created about a decade after the Mexican Revolution (1910–

1917) and continued to be formed until the constitutional reforms of 1992.

Mexico’s constitution put limits on the amount of land one person could

own and gave landless agricultural laborers the right to petition the

government for the excess land. The 1992 reforms stopped the creation of

new ejidos and created a process for breaking up existing ones by turning

them into private landholdings. The reforms do not require change, and

most ejidos continue to operate the same as they did before the reforms,

although some have been privatized and the land has been sold. At the

same time that the government opened an avenue for buying and selling

ejido lands, it cut many of the subsidies it had given to small farmers. In

the long run, changes in the level of subsidies for small farmers have been

more important than the new markets for ejido lands—and not always for

the best.

According to the Mexican Census of Agriculture, in 2007 there were 31,518

ejidos, with 4,210,899 members (including people living on the communal

lands of indigenous communities). This is approximately 72–73 percent of

the labor force in agriculture in Mexico. On average, ejido farmers tend to

own less valuable lands, have smaller individual plots of land than more

commercially oriented farms, and produce a disproportionately small

share of the nation’s agricultural output. This is not to say that all ejido

farmers are poor, but many of them lack access to markets, to capital, and

to technical knowledge that would allow the members to earn a decent

living.

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In 1992, Mexico rewrote the section of its constitution that allowed for the

creation of ejidos. The administration of Mexico’s president, Carlos

Salinas, argued that ejidos created disincentives for investment in

agriculture, which kept productivity low and contributed to rural poverty.

Some economists shared this view, but others were not so certain. The

argument of the reformers was that the lack of complete ownership rights

and ejidos’ small plot sizes inhibited the use of machinery and other

productivity-enhancing investments. Regardless of the analytical

correctness or incorrectness of the causes of low productivity on ejidos,

the vast majority of Mexico’s poor people lived in rural areas and worked in

agriculture, often as members of an ejido. In 1992, about 25 percent of the

labor force was in agriculture, but it produced only 9 percent of GDP. One

explicit purpose of the change in subsidies for small farmers and in

ownership rights of ejido members was to reduce the size of the

agricultural labor force by creating incentives to combine land holdings

and to apply modern production technologies. In 1992, the undersecretary

of agriculture stated that the goal was to reduce the share of labor in

agriculture from 25 percent of the labor force to 15 percent.

Eighteen years later, in 2010, 13.1 percent of the labor force was in

agriculture (compared to less than 2 percent in the United States and

Canada). The highest levels of poverty continue to be concentrated in rural

areas, and small-scale agriculture continues to struggle even as larger,

more modern and productive farms do well. NAFTA opponents frequently

blame the trade agreement for the difficult conditions on many ejidos and

small farms, but Mexican agricultural policy plays a far larger role. Corn

shows why. Corn is a dietary staple for many Mexicans and the main crop

on many small farms. Under NAFTA, Mexico’s import duties on corn were

scheduled to be phased out over a fifteen-year period, but Mexico

unilaterally cut tariffs ahead of schedule and increased imports from the

United States, in part to lower the price of corn for animal feed, increase

the size of the country’s livestock herds, and expand the amount of animal

protein in the diet of the average Mexican citizen. Mexico’s larger and

more commercial farmers expanded their corn production along with the

growth in imports, and the total amount produced nationally increased.

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Nevertheless, small-scale farmers who operated at near-subsistence levels

of production were badly hurt by this strategy because it lowered corn

prices at the same point in time that the government cut subsidies to

small farmers.

NAFTA allows each country to subsidize its farms as little or as much as it

chooses. Mexico provided approximately US $8.4 billion in farm supports

(subsidies) in 2014, but much of this went to farmers who were relatively

better off. That level of subsidies is equal to 13.3 percent of the gross

receipts of farmers. By way of comparison, in the United States, farm

subsidies are 9.8 percent of farm receipts (see Table 7.3 ), according to

the Agricultural Outlook of the Organization for Economic Co-operation

and Development (OECD). The decision to downsize the agricultural sector

was independent of the decision to sign a trade agreement with the United

States and Canada, and clearly it did not take into account the plight of

farmers who have few options other than a small plot of corn.

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