Commentary Type

What Is NAFTA, and What Would Happen to US Trade without It?

Chad P. Bown (PIIE)


President Trump has put the North American Free Trade Agreement—NAFTA—on notice. Canada and Mexico are gearing up to renegotiate the agreement, and Trump has stated that a failure to conclude a renegotiated deal to his liking could lead the United States to withdraw.

Here are five key things you need to know about NAFTA.

1. NAFTA involves three trade partners

NAFTA came into force between the United States, Canada, and Mexico on January 1, 1994. NAFTA added Mexico to a previous Canada-US Free Trade Agreement, or CUSFTA, that had been in place since 1989.

The George H.W. Bush administration had negotiated NAFTA, and Bush signed the agreement on behalf of the United States on December 17, 1992. When Bush lost his reelection bid, it was up to the newly elected President Bill Clinton to ultimately add the tweaks necessary to ensure political passage through Congress in 1993.

2. NAFTA cut import tariffs and had a modest economic effect on the United States, albeit with some localized losses

Under NAFTA, the three countries each cut their import tariffs to zero for virtually all manufactured products traded between them.

Trade between the three countries grew considerably. For example, US total goods trade with Mexico and Canada—imports and exports combined—grew from $291 billion in 1993 to $1.1 trillion in 2016. That 267 percent increase seems like a lot, but US trade with countries not in NAFTA also grew by 242 percent over that same period.

Economists face a challenge in pinpointing NAFTA’s exact effects because at least three other major global shifts were taking place almost simultaneously.

The overall effect on US labor because of increased imports from Mexico was much smaller than, for example, US manufacturing job loss because of automation.

First, the US tariff cuts on Mexican trade under NAFTA were enacted alongside cuts to most other countries when the United States entered the World Trade Organization (WTO) in 1995. Second, China rejoined the global economy and became a major exporting country during this same period. And technological advances—the Internet, information and communication technology, automation—transformed how businesses operate across the US economy. These changes affected manufacturing in particular.

Economists Shushanik Hakobyan and John McLaren have documented communities of US workers that suffered stagnant wage growth because of NAFTA. However, the overall effect on US labor because of increased imports from Mexico—even ignoring positive effects arising because of jobs tied to US exports—was much smaller than, for example, US manufacturing job loss because of automation. And Mexico’s effect on US labor markets is much smaller than the “China shock” that other economists have chronicled.

A renegotiated NAFTA that would reestablish trade barriers is unlikely to help workers who lost their jobs take advantage of new employment opportunities.

This is not to play down the problem of US job losses—but NAFTA isn’t a leading cause. And a renegotiated NAFTA that would reestablish trade barriers is unlikely to help workers who lost their jobs—regardless of the cause—take advantage of new employment opportunities.

3. Trump isn’t a fan of NAFTA—but it’s not quite clear why

Countries that trade a lot tend to have more to fight about, but trade agreements provide for dispute resolution. Washington, Ottawa, and Mexico City have litigated dozens of cases against one another, using WTO trade dispute mechanisms.

These cases were nothing exceptional—NAFTA countries resolved disputes over cattle, hogs, beef, tomatoes, wheat, corn, sugar, soft drinks, wine, tuna, lumber, steel, cement, and telecommunication services. None of these disputes ever escalated to threaten the existence of NAFTA.

Those trade skirmishes shed no light on what it is about NAFTA that Trump finds so irritating now. And they also don’t seem to be informing his negotiating strategy.

Trump’s public comments have focused on the bilateral trade deficit with Mexico. He has used Twitter to call out such US companies as Carrier, Ford, and General Motors for having established or moved production facilities to Mexico. And he has intermittently threatened Mexico with a 35 percent import tariff and other types of border taxes.

4. Other contentious elements of NAFTA: Investment, labor, and environmental standards

Almost from the beginning, it seemed everyone disliked something about NAFTA. Three items stand out.

The Clinton administration entered office in 1993 and negotiated two new side agreements. Once these deals on labor and the environment were made, Clinton submitted NAFTA to Congress, where more Republicans voted for NAFTA than Democrats.

The North American Agreement on Labor Cooperation, or NAALC, was the first attempt for a US trade deal to address labor standards. It was meant to appease US labor unions concerned that a pact with Mexico would trigger a race to the bottom and a deterioration in American wages and workplace conditions. Nevertheless, unions were worried that the NAALC still had major problems. They feared that the right of workers to organize, bargain collectively, and strike could not be enforced in Mexico through trade sanctions. Without enforcement, US workers feared a loss of their own competitiveness relative to Mexican labor earning lower wages.

The second Clinton compromise was the North American Agreement on Environmental Cooperation, or NAAEC. To environmental groups, the NAAEC also fell short: It was designed more as a forum for cooperation and dialogue. It did not provide a means for litigation and trade sanctions to be used as a tool to further regional environmental progress.

Third, NAFTA gave rights to foreign companies through something called investor-state dispute settlement, or ISDS. Suppose the government of Mexico nationalized a GM or Ford auto plant in Mexico City, or implemented an environmental or labor law that only applied to the US facilities in Mexico and not their Mexican competitors. Under ISDS, the US companies could sue the Mexican government. Civil society critics were troubled that ISDS is both nontransparent and provided foreign investors in each country—including in the United States and Canada—rights not available to domestic investors.

President Obama’s attempt to renegotiate NAFTA—through the Trans-Pacific Partnership, or TPP, agreement—addressed some of these concerns. The TPP made more labor and environmental provisions “enforceable” through trade sanctions. It also attempted to improve ISDS. But the TPP wasn’t limited to Canada and Mexico—it expanded coverage to include nine other nations across the Pacific Rim.

5. The initial NAFTA fallback

If the United States withdrew from NAFTA, other trade agreements could kick in. Because the NAFTA countries are all WTO members, at worst each must apply the import tariffs they offer to all other WTO countries.

New US tariffs on imports from Canada and Mexico could increase to an average of 3.5 percent. For new trade barriers facing US exporters, Canada’s import tariffs would increase to 4.2 percent and Mexico’s would increase to 7.5 percent.

But an asymmetric outcome—Mexico applying higher WTO tariffs against US exporters than the United States applies against Mexican exporters—would seem antithetical to what Trump wants to achieve. Indeed, the only completely symmetric or “fair” deal on tariffs would seem to be the zero percent tariffs that each applies under the existing NAFTA.

If the United States withdraws from NAFTA, it is also possible for the United States and Canada to revert to the zero tariffs they granted each other during the CUSFTA years of 1989–93. For Canada and Mexico, they could choose to continue to implement the terms of the NAFTA just between each other.

Less clear is what happens to cooperation over areas like labor, the environment, or foreign investment. Unlike tariffs, labor and the environment are not covered in any other trade agreement that the United States has with Mexico. And the United States also does not have a bilateral investment treaty in force to protect US company investments in these countries.

Will Trump borrow from any of the labor, environment, and investment provisions of the TPP for his NAFTA renegotiation? That’s a big question—but it’s one of many. Trump’s NAFTA renegotiation initiative leaves the international commercial interests in each of the three countries in a substantial state of uncertainty.

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