Trade agreements are still an important issue. The arguments for and against NAFTA outlined below are the same ones we hear with regard to the Columbia and South Korea free trade agreements which are currently hung up in congress. So hopefully the ideas are topical even if NAFTA is not.
The North American Free Trade Agreement passed by congress late last year generated a great deal of public attention. There was much discussion of its potential harms and merits in the media. This discussion, while not all bad, did not seem to me to be focused on the real economics of the issue.
NAFTA is now law and a fact of life for at least the foreseeable future. But, we still face many of the same policy decisions on different fronts. Whether the issue is the General Agreement on Tariffs and Trade (GATT), our ongoing negotiations with the Japanese, or political pressure by domestic firms for protection from imports, we, as citizens of the United States will continue to face the choice between free trade and trade restrictions.
It is my hope that I can discuss in a rather general way the benefits and costs of free trade and in this context say something about the likely impact of NAFTA on the U.S. and Mexico.
I would like to start with an illustration, if I may, of the potential gains from free trade.
In order to boil the argument down to its bare essentials let us construct a simple model of the economy. I want to make some very gross oversimplifications, not because I think they are accurate, but because they will help us focus on the important aspects of the issue.
Let us assume for the time being that there are only two goods produced and consumed in the whole world: tennis shoes and personal computers. Assume that tennis shoes are produced in factories using lots of manual labor. PC's, on the other hand require the use of sophisticated machinery and relatively little labor. Suppose that Mexico and the U.S. have tariff barriers that are so high that no trade at all occurs; (again I am not trying to be too realistic, but to illustrate a point as sharply as possible).
In such a world, both Mexico and the U.S. would be forced to produce everything they consume. There would be firms in the U.S. producing both tennis shoes and PC's. And the same would be true in Mexico.
Suppose for the sake of simplicity that the U.S., if it chose to could devote all it's labor and capital to the production of PC's and produce 100 of them (a nice round number). If we instead chose only to produce tennis shoes we could also produce 100 pairs. Since we have to produce both the market would dictate that we not end up at either extreme. We would instead produce something like 50 PC's and 50 pairs of tennis shoes.
In Mexico, where labor is more abundant and capital is scarce, the economy could produce 200 pairs of tennis shoes at one extreme or 50 PC's at the other. Again the market will dictate production somewhere in between, say 25 PC's and 100 pairs of shoes.
Thus, in this world with no international trade there are 75 PC's produced and 150 pairs of shoes.
Since there is little capital in Mexico and no trade. Capital would be very expensive and labor relatively cheap. Since PC's require alot of capital to produce they would be relatively expensive to produce, while tennis shoes would be very inexpensive.
Now imagine that trade between the U.S. and Mexico is opened up. Where would people buy their PC's? In the U.S., of course where the cost of capital is lower. Similarly people would turn to Mexico for tennis shoes where the cost of labor is lower.
As a result we might see the U.S. cease production of shoes entirely. The footwear industry would fall "victim" to international competition. Similarly the Mexican computer industry would disappear. Where does this leave us? We said earlier that the U.S. could produce 100 PC's if that is all it produced and Mexico could produce 200 pairs of shoes if it produced only shoes. As a result we would end up with 100 PCs as opposed to the 75 we had with trade restrictions and 200 pairs of shoes as opposed to the 150 previously. Very clearly the world as a whole is better off. In other words there are gains from trade.
One might, of course, be interested in how the gains from trade are distributed. In our simple world this is what would happen. As the U.S. stopped producing footwear some capital and alot of labor would be freed up. However, the computer industry does not normally require alot of labor. One of two things must happen, either workers must accept lower wages to entice computer firms to hire them, or some workers must remain unemployed.
An exactly identical argument for Mexico predicts that the return on capital must either fall, or capital must lie idle.
At this point it is tempting to conclude that while NAFTA will probably bring net gains is does so by rewarding U.S. owners of capital alot and harming U.S. workers. This is not the conclusion one should draw, however.
While trade between the U.S. and Mexico stands restricted until NAFTA takes full effect, capital is free to move across international boundaries. We therefore expect capital to seek it highest return. This would lead, in our simple model, to a flow of capital into Mexico even if trade in tennis shoes and PC's was completely shut down. The results for world production would be exactly the same as for the case with free trade. If labor were mobile across international boundaries we would see flows of labor from Mexico into the U.S. and again we would reach the same total production as with free trade. In fact it is a standard result of many models of international trade that free movement of capital or labor is identical to free trade in goods.
If we take this twist at face value we are left with the conclusion that all the fuss over NAFTA was a waste of time, there should be no real gains from trade as they are already exhausted by the fact that capital free to move between the U.S. and Mexico. This is not the conclusion one should draw either.
Let me now consider a more realistic (but still highly simplified) view of the issue. Suppose capital is free to move and that there is now trade in PCs or tennis shoes. Also suppose that there are two types of labor, skilled labor which is used alot in the production of PC's and unskilled labor which is used alot in tennis shoe manufacturing. If we assume that there is more skilled labor in the U.S. and relatively more unskilled labor in Mexico, then we con return to our original results and substitute the word skilled labor for capital.
That is that skilled labor in the U.S. will get higher wages as production in PC's goes up, while unskilled labor will be forced to take wage cuts or be unemployed. Similarly, the wages of unskilled workers will rise in Mexico and wages for skilled workers there will fall.
This is, I believe, a realistic general prediction for the effects of NAFTA.
Let me add a final caveat. While we can predict the direction that wages will move, we cannot say anything about the size of the changes unless we know something about the sizes of the two economies. My earlier example used economies of roughly the same size. In reality the Mexican economy is much smaller than the U.S., not only the population lower (90 vs. 250 million or 1/3rd), but it's productive capacity is much smaller ($960 billion vs. $6000 billion for 1992 or 1/6th)
This tends to amplify the effects for the smaller country and mitigate them for the larger one. Thus, one would predict some lowering of U.S. unskilled wages and some moderate increases in skilled wages, but a much greater rise in Mexican unskilled wages. This is also generally true for the gains from trade. Small economies tend to benefit more from opening trade than large ones. Thus, the Mexicans are the ones who stand to gain alot, and who will most likely experience the greatest changes in employment, production and wages. Let me stress that the U.S. stands to gain as well, but not as much in percentage terms or per capita as Mexico.
I would like to present and examine some of the arguments I have heard opposing NAFTA and other free trade arrangements.
1.) NAFTA will cause jobs to be lost in the U.S. The argument goes something like this: As we open our borders to foreign produced goods, U.S. firms will either pack up and move south of the border or will be driven out of business by firms already there. This will leave a large portion of the workforce in the United States unemployed, perhaps permanently so.
As we have seen from our simple model, there will undoubtedly be some loss of jobs to Mexico. These will tend to be jobs in industries that rely on large amounts of relatively unskilled labor. Certainly the textile industry stood to lose alot from Mexican competition under NAFTA, until textiles were largely excluded from the agreement.
The U.S. faced a similar circumstance in the early 1980's when the steel industry in the U.S. began to loose market share to foreign produced steel. Some protections were put in place, but not enough to completely protect the industry. Many steel plants were closed and the steel belt turned into the "rust belt" as the suppliers of steel mills also closed their doors. Yet we do not see vast armies of unemployed steel workers in these areas today. Many took early retirement, most found new jobs, and many young people looked elsewhere for their first job. It is difficult to determine exactly how worse or better off the steelworkers were after they lost their jobs, but they were not tremendously worse off and they did not become chronically unemployed. Consumers in general benefited from lower steel prices
Time magazine ran an article last fall prior to the NAFTA vote which spotlighted Dayton, Ohio. They noted that a local auto parts manufacturer had already closed shop and opened a new plant across in Mexico. They also noted that a local manufacturer of heavy equipment had moved to Mexico at roughly the same time and had recently moved back because of a scarcity of skilled labor which they needed in assembly of their complicated machinery.
This indicates to me that U.S. labor can compete with Mexican labor even with large differences in wage rates. The anxiety workers seem to feel about NAFTA may be attributable to the fact that specific job skills are becoming increasingly important in the U.S. labor market.
The Wall Street Journal also ran an interesting article on Mexican shoemakers who were worried that NAFTA would wipe out their business. They produced fine handmade leather shoes, but doubted they could compete with cheaper lower quality mass-produced shoes from the U.S. It cite this article because it reveals that reservations about NAFTA cut both ways. We worry about cheap labor and the Mexicans worry about out high productivity.
I have noted alot of attention lately to the issue of jobs. Job creation seems to be a very important issue on many people's minds. This is an issue I have a bit of difficulty understanding. Creation of jobs is actually a very easy thing to do. We could, if we wished, pay people to dig holes and fill them up again. With a high enough wage we could entice everyone unemployed into a job.
I submit that most of us would think such an arrangement quite silly. This is because while we might generate jobs we don't generate anything in the way of goods and services that is of value. I think it is necessary when we look at various public policies to bear this in mind. Supporters and detractors of various policies will make all sorts of claims about the numbers of jobs lost or created; while the real issue should be how does it increase or decrease the welfare of the average citizen.
I cannot resist another illustration. Vice President Gore has argued publicly that increased environmental regulation will create jobs. This may well be true, at the extreme we could all be employed as environmental watchdogs making sure that everyone else does not pollute. But if we are all busy watching each other no one will be producing anything for consumption. It may well be that regulating pollution more strictly will make us all better off, but the argument should be made in terms of how it affects production of goods and bads, and not in the number of jobs it creates.
2) NAFTA will cause production in Mexico to rise (somehow) this will lead to exploitation of Mexican workers by firms in Mexico. Mexican labor laws are not as stringent as U.S. laws and thus firms will be less likely to provide clean, healthy and safe workplaces. Thus, with trade barriers in place we protect Mexican workers from exploitation.
The flaw with this argument is the assumption that Mexican workers are better off with no jobs at all than the ones new firms would generate. Certainly the Mexicans do not think so. The assumption, albeit an implicit one, is that Mexican workers are not smart enough to know what is for their own good. If the new jobs created are dangerous and worse than the jobs Mexicans have now, then the Mexicans will turn them down. The fact that they appear to want these jobs indicates that either the jobs are better than what they have, or they don't understand what is going on.
While it may be the case that jobs generated in Mexico will be less safe and pay less than those lost in the U.S. it really is none of our business as long as the Mexicans accept these jobs voluntarily. The decision on what level of safety and cleanliness should prevail in Mexican factories is fundamentally a Mexican decision.
One might argue that these decisions are made by a corrupt political system which does not have the best interests of the average Mexican at heart. This appears to less the case than in the past, but even if it is true it is not at all clear that the best way for the U.S. to address this problem (if indeed we should) is by keeping trade barriers up. It may, in fact, be the case that free trade is a very good dose of medicine for curing political corruption. Since corruption is costly, it is harder for corruption to exist when firms face stiff competition.
3) NAFTA will cause production in Mexico to rise (again somehow) and this will lead to contamination of the environment by firms in Mexico. Mexican environmental laws are not as stringent as U.S. laws and thus firms will be more likely to pollute the air and water in Mexico. If we allow trade barriers to remain in place we protect the environment.
This argument is subject to the same criticism as the previous one. That is, Mexicans should have the right to determine the level of pollution they are willing to live with, and not us. To the extent that we are concerned about air pollution blowing across the border into the U.S. we may be mildly concerned with lax environmental regulation in Mexico, but again there are better ways to deal with such problems, should they arise than restricting trade.
4) NAFTA will lead to a loss of U.S. sovereignty. This is because it creates several transnational bureaucracies to oversee the enforcement of the treaty. These bodies will have enforcement power which supersedes that of federal, state and local governments. Any current or subsequent laws and regulations which conflict with the provisions of NAFTA will be effectively eliminated. This means that policy directly effecting the lives and livelihoods of U.S. citizens will be under the control of commissions and many of these members, being Mexican and Canadian, will not have the best interests of the U.S. in mind.
I must admit to having a bit of sympathy with this view. Certainly an ideal NAFTA would not require the 2000 pages of addenda that were attached to this one.
Most of the enforcement granted under NAFTA was aimed rather explicitly at Mexico in the areas of labor practices and environmental protection. The indirect costs to the U.S. are likely to be small, and the direct costs of maintaining the enforcement agencies are a very very small portion of the overall government budget.
In any case NAFTA should not be dismissed on these grounds alone, if they are a net cost they still need to be weighed against the gains from trade.
Allow me one slight digression at this point. While I believe that NAFTA will result in net gains on both sides of the border, I do not think that NAFTA as written is the best agreement if realizing the largest possible gains is our objective. NAFTA was originally a 16 page document, to which several thousand pages o qualifications and exceptions were added over the course of its negotiation. Most of these were exceptions for specific commodities. There were also extensive sections dealing with pollution and labor regulation and their enforcement. Each of these exceptions protects a small group of producers or other interested parties. But they do so by lowering the benefits to the rest of us. In fact, were I to bore you with graphs and economic theory it would be straightforward to show that the cost to the rest of us outweighs their benefit.
An ideal NAFTA would have had something akin to article 1, section 9 of the U.S. constitution which states:
No tax or duty shall be laid on articles exported from any state.Indeed, the best example of the benefits of a free trade agreement is probably the United States. Imagine how different our economy would be if each state could levy tariffs on goods produced in other states.
No preference shall be given by any regulation of commerce or revenue to the ports of one state over another; nor shall vessels bound to or from one state be obliged to enter, clear or pay duties in another.
5) NAFTA will cause many industries in the United States to dwindle or disappear entirely. Some of these goods will be vital to national security. If these strategic industries are missing when a war breaks out, we will be in a very precarious position. Thus, these industries must be protected against such an scenario. Some of the industries cited as examples are heavy machinery, steel, petrochemicals, non-ferrous metal mining (tungsten, etc.).
While this argument may seem reasonable, it is a very unlikely prospect. Steel, for example, is available from any number of countries on international markets. The likelihood that each of these would declare war on us or be unable to supply steel is very small. Even if such a scenario were likely, a better solution would be to create stockpiles of strategic materials, this way we would get the goods at lower prices and still have them available if needed.
The strategic industries argument also lends itself easily to abuse. Any number of industries could be considered "strategic" by the appropriate interpretation of the word. Indeed, U.S. mohair producers are subsidized by the federal government using exactly this argument.
6) The United States is very good at doing basic research and development. We have arguably the best university system in the world. However, many of the ideas Americans develop first are produced and marketed by foreign firms. This is because foreign government support these industries while the U.S. government does not. Sometimes this support takes the form of government backed coordination, other times it take the form of outright subsidies which allow these industries to stay in business while making a loss. Thus, the U.S. should erect barriers to trade to protect these industries in their early stages of development. Once they are well established they will be able to compete without the aid of trade barriers, but such barriers are vital for early stages of the industry's development. This is referred to as the "infant industry argument".
As a general rule, infant industries that are protected from competition never grow up. Latin American countries, for example, are still carrying along many infant industries that sprang into being as early as 40 years ago. While the infant industry argument may make sense under limited circumstances, it is hard to find an example where an industry protected early on later flourishes without protection.
7) Foreign governments subsidize many well-established industries. Thus, while U.S. firms may equally or even more efficient, they cannot compete with foreign goods. The U.S. should step in and set tariffs to offset this unfair advantage. This levels the playing field and allows the most efficient firms (i.e. the U.S.) ones to compete.
From strictly a U.S. point of view this is exactly the wrong thing to do. By imposing trade barriers we force ourselves to buy goods which are produced at greater cost than on the world market. We would be better off if we produced something else as bought these goods from the subsidizing countries. It is as if the citizens of that country give us a gift; they allow us to buy the good at below cost. If this is what foreign countries wish to do, so be it. It is foolish on their part, but we would be just as foolish to throw the gift away.
8) Foreign firms often engage in dumping, that is they sell goods in the U.S. market at prices below those they charge in their own country; the price they charge may even be so low that it is below the costs of production. Foreign firms are willing to do this because they can undercut the prices of U.S. firms, drive them out of business and corner the market. Once there are no U.S. firms left producing, they can raise the price of the good and gouge consumers. Thus, trade barriers, compensate for the artificially low prices and keep foreign firms from gaining a monopoly.
It is difficult to see how a foreign firm could afford to raise prices substantially once it cornered a market. This is because any significant price increase would be sufficient incentive for a U.S. firm to begin producing again. Thus, the foreign firm must either sell below cost even after eliminating the U.S. producers (an unlikely event) or it must eventually raise its prices to competitive levels. There is a third possibility, which is the foreign firm is not, in fact, charging a price below its costs and is really a more efficient producer.
This indeed seems to be the case with the U.S. television industry. Japanese firms undercut the prices of U.S. television manufacturers in the early 1960's. As a result the U.S. producers disappeared or began to produce other goods (like computer chips in the case of Motorola). The price of televisions has not risen dramatically due to Japanese gouging, however. Mainly because Japanese firms still compete fiercely with each other in the U.S. market. As a result we get televisions at a much cheaper price than we could produce them here and we produce other goods intend, like pharmaceuticals and computers.
I hope I have been able to present accurately the arguments surrounding NAFTA. To summarize I think that NAFTA will be a net benefit to both the U.S. and Mexico. Although the gains are likely to be small in the U.S. because of our size and the numerous restrictions included in NAFTA. The winners from NAFTA in the U.S. are likely to be skilled labor and workers and owners in high-tech industries. The losers in the U.S. will be unskilled labor.
In Utah I see more gainers than losers. The workforce here is largely skilled and engaged in technologically advanced production. I include agriculture in this category; U.S. farming techniques are relatively capital and skill intensive. A great many of the goods & services we produce will be unaffected by free trade with Mexico because transportation costs are prohibitively high even without tariffs. We will not be competing with Mexican barbers and movie theaters, for example.
We will have opportunities as a nation in the future to expand the scope of our free trade. We may, for example, have a chance to include Central or South American countries in a NAFTA-like arrangement, we will continue to negotiate with Japan and with Europe. It is my hope we will have the foresight to seize these opportunities and not pass them by because of unfounded fears.
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