Issues in Economics: NAFTA: Fast Forward? Issues in Economics: NAFTA: Fast Forward?

June 2, 1997

NAFTA. For many, the acronym conjures up "bailout" or a "giant sucking sound." For others -- particularly in areas far from Mexico -- NAFTA may seem a nonevent with no discernible impact. So, why should New Englanders care about expanding the North American Free Trade Agreement to cover the entire hemisphere -- as the Clinton Administration and others have proposed? NAFTA's expansion may look vital in California or Texas, but does it matter in New England?

Why Have Trade Pacts?

Trade lets countries use their limited resources with greater efficiency and, thus, raises their income. By expanding the market, trade allows low-cost producers on both sides of a border to increase sales and employment. It also lets exporters reap added efficiencies from larger-scale or more specialized production, and gives importers access to less costly, better-quality goods. Finally, foreign competition spurs investment in new technology, a key ingredient in growth. Trade is, thus, a win-win exercise.

Of course, not everyone gains from trade. Added competition clearly hurts import-competing firms and their workers. In this regard, trade is like technical progress. Both improve an economy's overall efficiency by shifting resources to more productive uses, but short-run adjustment costs can be high, especially for the unskilled. However, trying to thwart technical change or impede trade are expensive ways to help these individuals.

The point of a trade pact then is simply to increase trade and, thus, living standards; it is not to produce a trade surplus or to create jobs. Trade increases incomes even if trade accounts are in deficit and no new jobs are created.

NAFTA in Particular

The considerations just outlined led to the extension of the U.S.-Canada Free Trade Agreement of 1989 to include Mexico starting January 1, 1994. The extension called for the removal of all tariff and many nontariff barriers between Mexico and its two northern neighbors over a 10- to 15- year period. The trade pact led to immediate tariff cuts on two-thirds of U.S. exports to Mexico, and on half of U.S. imports from Mexico; by now, its tariff provisions are largely in place.

What has NAFTA accomplished? Its impact has been neither disastrous nor negligible, even though its early years coincided with peso devaluation, a sharp drop in Mexican living standards, and the reversal of a U.S. trade surplus with Mexico to a sizable deficit. Clearly, with the U.S. economy in its sixth year of expansion and labor markets tight, neither NAFTA nor the peso crisis has wreaked havoc here. This outcome should surprise no one. While Mexico is our third largest trading partner, U.S. exports to Mexico represent less than 1 percent of U.S. GDP.

Given their size differences, and the fact that the two countries already traded extensively and relevant trade barriers were already fairly low, studies done before NAFTA usually concluded that the agreement would produce modest benefits both north and south of the Rio Grande. The pact was expected to raise Mexican output by 2 to 3 percent within two decades. For the United States, the predicted output gains were a fraction of 1 percent.

Do the early results match these expectations? The U.S. International Trade Commission, in the most comprehensive assessment of NAFTA to date, concludes that the pact has had a positive but small net impact on the U.S. economy in its first three years. The ITC found no evidence that NAFTA has had any effect (good or bad) on U.S. output or employment. But it did conclude that NAFTA had increased the annual volume of U.S. imports from Mexico by as much as 6 percent, and of U.S. exports to Mexico by as much as 4 percent during its first three years. And increasing efficient trade is, after all, NAFTA's primary purpose.

That researchers can find any empirically discernible impact is remarkable given the severity of the peso crisis, which dominated Mexican-U.S. economic relations from 1994 to 1996. Within a year of the start of NAFTA, Mexico faced a traumatic 40 percent fall in the value of the peso followed by a 10 percent drop in output. With such dramatic changes, it is no wonder the U.S. trade surplus of $1 billion with Mexico in 1993 turned into a $17 billion deficit in 1995.

Did NAFTA trigger that crisis? To some, the timing suggests that it did. But the peso crisis occurred largely because of the large gap between U.S. and Mexican rates of inflation. Prices rose an average 16 percent a year in Mexico between 1990 and 1994 but less than 4 percent annually in the United States. The exchange rate had to give -- with or without NAFTA.

Instead of triggering the peso crisis, NAFTA most likely speeded Mexico's recovery by encouraging rapid export growth and the prompt resumption of capital inflows. Thus, in contrast with the debt crisis of 1982, which left Mexico staggering for most of the decade, Mexican output began to recover from the 1994 crisis within a year. By 1996, U.S. exports to Mexico were 12 percent above their pre-crisis high.

The View from New England

New England shares the gains from NAFTA via added low-cost imports and domestic sales as well as exports. But export growth is easier to track. From 1987 to 1996, the region's NAFTA exports grew much faster than its non-NAFTA exports, and faster than U.S. NAFTA exports. The latter outcome reflects an early surge in New England exports to Canada; New England exports to Mexico have grown at a below-average pace. Despite declining transport costs, geography still matters.

Recently, however, the growth in the region's exports to Mexico has slowed even more than the nation's. Most likely, the peso's decline led to a surge in the importance of maquiladora (or border-area assembly plant) activity in U.S.-Mexican trade. Since U.S. exports to the maquiladoras are generally re-exported to the United States, they reflect demand conditions in this country, not in Mexico. Maquiladora trade was thus immune to the Mexican downturn, but blossomed as the peso's fall cut Mexican production costs. (NAFTA may have spurred maquiladora growth by signaling assured access to the United States and ongoing reform in Mexico, but this border trade predates NAFTA by decades.)

Although some maquiladora industries, like electronics, are big in New England, geography suggests that the region's exports to Mexico are largely destined for Mexico's domestic market. If so, New England exports would be more susceptible to the peso crisis than exports from Mexico's near neighbors, who are heavily engaged in twin-plant trade. As Mexico's domestic recovery continues, NAFTA's benefits for New England should become more apparent.

The recent weakness in New England exports to NAFTA partners suggests how the integration of neighbors with different factor costs can create a competitive challenge for these countries' nonborder regions. As seen along the Hong Kong-Chinese border as well as the Rio Grande, border areas may develop a dynamic pull affecting domestic investment and long-run growth. Here in New England, the economic vitality of the Mexican border area may have contributed at least modestly to the shift in jobs, particularly manufacturing jobs, out of this region since the late 1980s. Employment at the U.S. affiliates of Canadian firms has made such a shift to the Southwest. Thus proximity to Mexico helps to explain the strong growth in exports to Canada from Texas and other border states.

Hemispheric Free Trade?

Proceeding to hemispheric free trade would magnify NAFTA's modest benefits. Latin America (with Mexico) already represents a U.S. export market larger than Canada and almost as large as China plus all developing Asia. In addition, the IMF projects that Latin America will grow almost twice as fast as the major industrial countries in the near term. The trading opportunities are huge.

While the United States has yet to express serious, "fast-track" interest in hemispheric free trade, the region has become embroiled in a complex set of overlapping regional trade agreements, like Mercosur (composed of Argentina, Brazil, Paraguay, and Uruguay) that exclude this country. These regional pacts have led to trade, particularly in locally produced capital equipment, that does not reflect comparative advantage and is, thus, wasteful. Growth in Latin America will be faster if it is based on open trade policies that encourage efficient production. From a U.S. perspective, moreover, our exporters suffer by being excluded from these growing markets. Particularly important in New England are these countries' markets for financial services, telecommunications, and other capital goods. And since no U.S. state shares a border with any South American country, free trade with South America may pose fewer challenges for New England than does integration with Mexico.

Jane Little is an economist at the Boston Fed.

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