NAFTA in a Skeptical Age: The Way Forward
© Peterson Institute for International Economics
Road Rage Against Globalization-Why?
For many Americans, NAFTA became the serving bowl for a whole plate of discontents. NAFTA was negotiated in the era when the winning political slogan was "It's the economy, stupid." Since NAFTA was enacted in 1993, the U.S. economy has dramatically improved, yet the discontents have grown worse. I characterize these discontents as road rage against globalization. That's an exaggeration, to be sure. Nevertheless, since record prosperity has reached nearly every nook of American society, antagonism to the global economy is surprising. To cite the most contemporary example: if Permanent Normal Trade Relations (PNTR) with China were put to a popular vote, polls indicate that it might well be defeated-even though the United States is a big winner in the traditional arithmetic of mercantilism that drives most trade agreements. The United States gains abundant market access in China and gives little in return.
Road rage against globalization can no more be explained by individual trade agreements than road rage on the Los Angeles freeways can be explained by a fender bender mishap. The causes are deeper. Understanding them is essential to policy makers who want to pilot NAFTA towards deeper integration in the years ahead.
Activists, by definition, challenge the established order
In the 1890s, the established order was rapacious capitalism-embodied in the "Trusts". The Trusts dominated the economy and bought the politicians. Activists of that day, led by Theodore Roosevelt, set about breaking the Trusts. Their crowning achievement was the Sherman Act of 1890-subsequently used to dismantle Standard Oil, the Tobacco Trust, and a few others. This venerable legislation is once again in the limelight, following Judge Jackson's adverse ruling against Microsoft.
In the 1930s, following the collapse of Wall Street and Main Street, the established order of laissez faire markets and small government was in shambles,. The New Deal Democrats, led by Franklin Roosevelt, enacted far-reaching economic and social legislation. FDR's legislation sharply expanded the Federal role in the private economy.
In the 1960s, Vietnam became the rallying pole for political activists. Eventually the anti-war faction forced Lyndon Johnson to step down after a single full term and defeated Hubert Humphrey's bid for the White House. For the next twenty years, the spectacle of Vietnam shaped U.S. military policy, cautioning successive presidents against committing U.S. troops to foreign wars.
Globalization seems a pale reflection of the grievances that inspired political activists in past eras. It's amorphous, it doesn't offer ready legislative handholds, and even the extreme French opponents recognize some virtue in a more integrated world economy. But until something better comes along, globalization remains the cause du jour.
Globalization: intertwined with Anglo-Saxon capitalism
The most successful economic model of our times combines macroeconomic stability (the so-called "Washington consensus") with "Anglo-Saxon capitalism". The elements of macroeconomic stability-small fiscal deficits, low inflation, stable exchange rates-are relatively uncontroversial. The elements of Anglo-Saxon capitalism are highly controversial. They include: private rather than public enterprise; highly flexible labor practices; the possibility for corporations to grow and shrink rapidly; spectacular compensation for corporate executives; and a decisive role for finance in shaping the direction of firms. Finance works through initial public offerings (IPOs), share market valuations, mergers and acquisitions, and hostile takeovers.
The elements of Anglo-Saxon capitalism are intertwined with globalization. Successful firms "chop up" the value added chain and outsource production to multiple countries; they import and export intermediate components on a huge scale; they acquire domestic and foreign firms often using shares instead of cash; and they hire the best workers and managers, usually paying premium salaries.
Anglo-Saxon capitalism brings fast diffusion of new technologies and rapid productivity growth, as laggard firms are bought out, consolidated, and closed. But this brand of market organization spells turbulence in the workforce as firms expand and contract, and as talent is prized more than seniority. Today, few workers can count on lifetime job security or regular annual wage increments. Anglo-Saxon capitalism also spells stunning compensation packages for top executives. In the United States today, the typical CEO of a Fortune 500 firm earns more than 400 times an average worker; a generation ago, the ratio was 40. Needless to say, these features are not universally popular, and anxiety about Anglo-Saxon capitalism readily spills over to globalization.
Information technology, Bill Gates, and his billionaire friends
Around the same time that global finance, trade, investment were sweeping the world, together with Anglo-Saxon capitalism, along came the information technology revolution. Even without IT, other forces would have created a new crop of billionaires. With IT, the crop was larger and more spectacular. In 1982, when Forbes first began to chronicle the very wealthy, only 4 U.S. billionaires could be counted. In its July 2000 issue, Forbes identified 470 "working billionaires" around the world, 280 of them Americans. Of the global super-rich profiled, approximately half (including Bill Gates and other high-flyers) owe their billions to IT. Information technology, more than other new technologies, is seen as an enabling force for global finance, investment, and production.
"Gilded ages" are times of joy for the super rich, the rich and even the near rich. But they are times of resentment for millions of middle class citizens who are only doing ok. It's no coincidence that the gilded age at the end of the 19th century spawned a wave of populism and landmark anti-trust legislation. It's no coincidence that today's gilded age has stirred a backlash against globalization.
The American Missionary Spirit: Alive and Well
NAFTA's troubles do not end with the backlash against globalization. They are compounded by the fact that NAFTA in particular, and trade agreements in general, have come to be viewed as suitable vehicles for American missionary zeal.
In the 19th century, Christian missionaries carried not only religion, but a whole set of American values, to far flung peoples in Asia and Africa. In the 20th century, the United States fought two World Wars that might have been avoided if contemporary isolationists had prevailed. Instead, the American people elected Woodrow Wilson and Franklin Roosevelt, leaders who personified U.S. zeal against autocrats and aggressors. The same spirit enabled Harry Truman to set the course for forty years of Cold War against the Soviet Union.
Today, the American missionary spirit seeks to spread democracy, human rights and religious freedom, as well as labor and environmental standards, around the globe. The preferred vehicles are commerce withheld (through economic sanctions) and commerce extended (through trade agreements). While economic sanctions have long been an instrument of U.S. foreign policy, Jimmy Carter gets credit for invoking this ancient weapon to promote human rights and religious freedom. The connection between trade agreements and labor and environmental standards was first forged, in a significant way, in NAFTA, especially the "side agreements" negotiated at the insistence of Bill Clinton.
Reality Check: The Pay-Off from Open Markets
Globalization protest is all the rage. The media loved the Seattle ruckus in December 1999, the World Bank/IMF rally in April 2000, the destruction of McDonald's in France, and the "trial of globalization" near Bordeaux in June 2000. Rising standards of living are boring compared to street theatre. But since living standards matter, it's time for a reality check on the benefits of open markets.
Step increase in per capita income
Estimates made of the benefits of trade liberalization, using partial equilibrium and computable general equilibrium models, indicate that per capita income gains range from 20 percent to 50 percent of the increased trade volumes.1 In other words, if liberalization increases imports (or exports) by $100 million, the country's income will rise by $20 to $50 million.
- Between 1990 and 1999, Canadian exports grew from $126 billion to $237 billion. If Canadian exports had grown only as fast as real Canadian GDP (plus U.S. inflation), the 1999 figure would have been $184 billion. The extra $53 billion of exports can reasonably be attributed to NAFTA and the WTO. The boost to Canadian GDP potential was $11 to $26 billion (2 to 4 percent).
- Between 1993 and 1999, Mexican exports grew from $48 billion to $120 billion. If Mexican exports had grown only as fast as real Mexican GDP (plus U.S. inflation), the 1999 figure would have been $63 billion. The extra $57 billion of exports boosted Mexican GDP potential by $12 to $28 billion (3 to 6 percent).
- Between 1990 and 1999, U.S. exports grew from $251 billion to $700 billion. If U.S. exports had grown only as fast as U.S. GDP, the 1999 figure would have been $400 billion. The extra $300 billion of exports boosted U.S. GDP potential by $60 to $150 billion (1 to 2 percent).
Why does more trade-both imports and exports-increase per capita income levels? There are many reasons.2 The law of comparative advantage kicks in; producers become more efficient in response to import pressure; firms are able to spread high fixed costs over longer production runs; firms and households are able to buy the goods and services that precisely meet their needs, not close approximations.
We have recently quantified one benefit of trade integration-narrowing the range of price dispersion.3 Border frictions add millions of miles to price divergence between urban areas. Price divergence between U.S. and Canadian cities is almost twice as large as price divergence within the United States. It is much larger between the United States and Mexico.
- If Canadian price divergence could be narrowed to plus or minus two standard deviations around the U.S. average, Canadian GDP would increase by nearly 3 percent.
- If Mexican price divergence could be similarly narrowed, Mexican GDP would increase by nearly 11 percent.
As large as the NAFTA trade gains have already been, they are just the beginning. Recent estimates suggest that, with complete integration and dollarization, the ratio of Mexican trade (imports plus exports) to GDP could grow from 60 percent (the current level) to as much as 150 percent. For Canada, the ratio might grow from 70 percent to more than 150 percent.4 Trade on this scale would bring much closer price convergence between urban areas in North America, far more competitive markets, and large step gains in Mexican and Canadian per capita income levels.
Integration with world markets not only triggers a step increase in income levels. It also fosters higher growth rates.5 The United States has certainly benefited from rapid integration in the 1980s and 1990s, with the boost to productivity in numerous industries (electronics, autos, steel, pharmaceuticals, telecommunications ) and the low-inflation associated with a high-flexibility economy. On the basis of its research, the World Bank suggests that "fast integrating" emerging economies will grow 1.5 to 2.0 percent faster per year than others.6 A.T. Kearney pegs the growth difference between "aggressive globalizers" and others countries at 4.0 percent per year.7 Frankel and Rose suggest that trade integration alone, in the context of currency union, might increase growth by 0.8 percent per year over 30 years.8 Bluntly speaking, there is little reason that Canada cannot grow by 1.0 percent per year faster than the United States for at least five years (after all, Canada has a reservoir of unemployed workers). There is no reason at all that Mexico cannot grow 2.5 percent per year faster for decades-if it combines trade integration with financial liberalization.
Financial liberalization and financial depth dramatically improve the efficiency of investment. The contribution of efficient investment to GDP growth is at least a percentage point a year. That's the difference between 20 percent of GDP invested at an annual return of 10 percent, and the same share of GDP invested at an annual return of 15 percent. In a word, that's the difference between many investment projects in Canada and Mexico, and their counterparts in the United States. One component of financial depth is a well-run banking system-a feature Mexico is beginning to acquire as domestic banks partner with European and U.S. banks. Another component of financial liberalization is greater reliance on share markets to raise capital, and less reliance on bank finance. While the whole of North America is turning to stock markets, the shift in the United States has so far outpaced Canada and Mexico:
- Canadian stock market capitalization increased from 45 percent of GDP in 1990 to 92 percent of GDP in 1999.
- Mexican stock market capitalization increased from 15 percent of GDP in 1990 to 25 percent in 1999.
- U.S. stock market capitalization increased from 53 percent of GDP in 1990 to 154 percent in 1999.
Open markets fundamentally alter the trade-off between higher employment and lower inflation. Open markets dramatically enlarge the number of competitors. As a result, far fewer firms and workers command market power that can translate into potential inflationary pressure.
- OPEC seems to have revived-at least for the moment. But what other commodity cartel still has market power?
- What about the industrial oligopolies of the 1970s? Autos, steel, telecommunications, computers, power generators, airlines Gone, gone, gone!
- Result: the United States can enjoy double fours-4 percent growth and 4 percent unemployment-keeping inflation under 3 percent. So can Canada. Mexico can certainly reach double sevens-7 percent growth and 7 percent unemployment-keeping inflation under 5 percent.
Dealing with Tension
Tension obviously exists between political backlash and missionary spirits on the one hand, and the tangible benefits of open markets and more intense integration on the other. This tension was played out in the U.S. Congressional vote over PNTR between the United States and China. Stripped to its essentials, the bilateral U.S.-China accord brings to an end the annual NTR debate-a vent for American criticism of Chinese policies. In exchange, China slashes its trade and investment barriers. As a consequence of PNTR, the United States and China agree to mediate their trade and investment relations through the WTO framework. PNTR required no commercial concessions of the United States-no liberalization of tariffs or quotas. Even so, the battle for Congressional approval was hard fought. A dedicated coalition of labor, religious, and environmental groups-the AFL-CIO, the Christian right, Public Citizen, the Sierra Club-fought the accord. All the energies of the Clinton administration and the business community were required to secure a 237-197 favorable vote in the House of Representatives in May 2000. During the last weeks of Congressional battle, the prevailing forces spent less energy praising PNTR for enhanced market access to the China market, and more energy arguing the contribution that freer trade and investment will make to democratic values and human rights in China. The last battle, in short, was fought on the turf of the antagonists, not the protagonists of PNTR. Faced with this history lesson, what strategy should NAFTA protagonists adopt as they seek to deepen the North American accord?
First Strategy: Head-On Confrontation
Under this strategy, the protagonists of freer trade and investment would fight a pitched battle with NAFTA naysayers, just as they did with PNTR opponents. The protagonists would compromise with reasonable environmental and labor advocates, but draw a line against the AFL-CIO, the Sierra Club and Public Citizen. The protagonists would urge the next president to push for fast-track authority to launch a range of trade and investment accords, including the next WTO round, negotiate the FTAA, and deepen NAFTA. Specifically with respect to NAFTA, the negotiating authority would enable the president to negotiate:
- Free agricultural trade between the United States and Canada (free agricultural trade is already committed, under NAFTA, between the United States and Mexico.
- The elimination of antidumping actions between the NAFTA members.
- More liberalized rules of origin in NAFTA commerce, particularly in the auto, electronics, and textile and clothing sectors.
- Paperless customs, factory inspections, and sealed containers, so as to reduce congestion at the border for pre-approved trucks.
- Agreed labels for meeting environmental and labor standards in NAFTA trade, backed up by a system of civil fines, but not trade sanctions.
- An examination of the possible scope for tax convergence, starting with a framework for facilitating E-commerce within NAFTA.
- An approach for welcoming Mexico and Canada into a "dollar zone", if they decide to fix their currencies to the dollar, either by a currency board or adoption of the dollar itself.
The head-on strategy has major drawbacks
The head-on strategy cannot be labeled a "non-starter", but it does have three major drawbacks.
First, and perhaps most troubling, the United States is prosperous, complacent and disinterested-disinterested in a deeper relationship with its NAFTA neighbors, or for that matter, with the rest of the world. Frankly, most Americans don't see their standard of living tied to more intense trade and investment flows. They are mistaken, but unlike most Mexicans and Canadians, most Americans do not see world commerce as an engine of domestic growth. And with the end of the Cold War, Americans no longer see open markets as the cement for political alliances. Those who advocate policy linkage-strong labor, environmental, and anti-drug standards embedded in trade agreements-start with an advantage. If the president and the business community want deeper trade and investment integration in North America, without the "baggage" of stringent conditions on social issues, they must make an all-out effort to sell the American people.
If Al Gore is elected president, he would have to stiff his core AFL-CIO supporters, and other elements of his liberal coalition, to embrace the head-on strategy. That seems highly unlikely.
Nor would the head-on strategy be a easy sell with George Bush, if he is elected. As president, Bush might well need to expend greater political effort to deepen NAFTA with Canada and Mexico, than to enlarge NAFTA to encompass the Caribbean and Central America. Once Fidel Castro falls, Cuban membership in NAFTA seems almost foreordained; and with Cuba in the club, it will be relatively easy to extend the accord to the rest of the Caribbean and Central America. Indeed, with the recently enacted United States-Caribbean Basin Trade Partnership Act,9 the economics of freer trade and investment between the United States and this region are already well underway. Collectively, the countries of the Caribbean and Central America number 65 million, but individually they are small, and their main exports do not seriously threaten important U.S. industries. By contrast, deep integration between the United States, Mexico and Canada will touch sensitive nerves, particularly in the United States.
Second Strategy: Build Institutions
The Field of Dreams answer to deepening NAFTA is to build North American institutions as a pathway to closer economic ties. Sponsors of this approach contrast the European Union with NAFTA.10 The EU is rich (perhaps too rich) in regional institutions-from the European Commission, to the European Court of Justice, to the European Cohesion Fund. By contrast, the NAFTA is poor (perhaps too poor) in regional institutions. Article 19 mechanisms usually work to resolve countervailing duty and antidumping disputes, but the environmental and labor institutions are deliberately weak. A robust institutional approach would have several components:
- Invigorate the Border Environmental Commission (BEC) and the North American Development Bank (NADBank), with substantial funding, to attack the problems of infrastructure and environment along the 2000-mile U.S-Mexico border.
- Strengthen the Labor and Environmental Commissions, giving the greater funding and more autonomy.
- Create new senior level commissions to examine drug and immigration issues.
- Hold informal meetings between central bankers to explore monetary and financial issues, and perhaps a common currency. But take no action.
- Hold tripartite meetings between key committees of the three legislatures, and biennial summits between the heads of state, to chart the agenda.
The institutional strategy has its own flaws
Like the head-on strategy, the institutional strategy has flaws. The U.S. executive branch departments and the Federal Reserve are jealous of their authority. The Congress dislikes the whiff of shared sovereignty. Even informal meetings might be seen as the beginnings of power-sharing exercises
Meanwhile, most Americans are bored with, or antagonist towards, new international institutions. They see well-paid bureaucrats, endless studies, and a possible threat to local authority. Decades could pass before American opinion demands deeper institutional ties with Mexico or Canada.
In other words, from the standpoint of prosperous and complacent United States, Field of Dreams might be a fine approach, if it didn't have teeth and didn't cost money. From the standpoint of Mexico and Canada, an institutional approach under these conditions wouldn't do much to accelerate integration.
Third Solution: Act First, then Talk
That leaves the unilateral approach-unilateral action by Canada and Mexico to deepen NAFTA. Prosperous America is doing fine, thanks to open markets, a flexible work force, and information technology. Canada and Mexico are doing all right, but compared to the golden age in the United States, both are lagging. Measured at purchasing power, Canadian per capita GDP reached 90 percent of the U.S. level in 1990, but only 78 percent in 2000. The Mexican per capita GDP was 23 percent of the U.S. level in 1990, but only 21 percent in 2000. To be sure, national GDP per capita figures conceal wide variations between regions. In Canada, Vancouver, Calgary and Edmonton are doing very well; in Mexico, the northern states are booming. But there is no reason why Canada and Mexico as a whole should not be converging on U.S. standards of living.
The act-first, talk-later strategy would find Mexico and/or Canada taking major unilateral steps to promote deeper integration:
- Fix the Canadian dollar and/or the Mexican peso to the U.S. dollar. Start with currency boards, then move to a single currency. Benefits: lower interest rates, higher share values, and faster price convergence now. Under this strategy, Canada and Mexico would act first, and then negotiate-on a timetable comfortable to the United States-the questions of seigniorage and monetary policy.
- Adopt tax systems that are ultra-friendly to corporate investment and skilled professionals. The unfriendly Canadian system hits individuals with a marginal rate of 53 percent at C$60,000, while most firms pay a corporate rate of 43 percent. By contrast, the U.S. system is tolerable, and the Mexican system is friendly.
- Do everything possible to make the border permeable to E-commerce. Facilitate parcel delivery, make tax collection ultra simple, even if it costs some revenue. Mexico can do itself a big favor by investing in border infrastructure, and recouping the outlay with appropriate tolls.
- Reduce external tariffs, where higher, to the lower U.S. rates, and then abolish rules of origin on shipments from NAFTA partners. There is no reason-other than pure protection-to maintain rules of origin if the external third country tariff maintained by Mexico or Canada does not exceed the U.S. level. In these circumstances, no manufacturer is going to ship a component to New York, and then truck it to Ontario, to escape the Canadaian tariff; nor will a manufacturer ship to San Diego and truck the component to Juarez to save the Mexican tariff. Once Canada and Mexico have abolished their own application of rules of origin, they should challenge the United States to do the same.
- Suspend antidumping duties unless the U.S. imposes new penalties. Practice case-by-case retorsion,11 but otherwise let the dreadful statute quietly expire in the North American context.
One big drawback
The unilateral strategy has one big drawback. Canadian and Mexican leaders must act on the proposition that sovereignty is about economic performance, not symbols. This is a small step for economics but a giant step for politics. The old formula of reciprocal bargaining can only work to the detriment of Canada and Mexico, and slow their deep economic integration with the United States. It comes down to a simple proposition. Economic policies unilaterally implemented-currency, tax, tariff and transportation-will ensure a swift rise of Canadian and Mexican per capita income to U.S. levels. If Canada wants to close its per capita income gap over the next 20 years, these are the proven policy tools. Others may exist, but these are tried and true. If Mexico wants to close its gap over 60 years, the same tools are at hand.
1. Estimates of the effect of trade liberalization on income levels are collected in Gary Gary Hufbauer and Erika Wada, "Impact of Dollarization on Trade, Prices, Finance", Conference paper, Strategic Assessments Group, November 1999, Table 1.
4. More conservative estimates are given in Hufbauer and Wada, op. cit. The estimates in the text are based on Jeffrey Frankel and Andrew Rose, "An Estimate of the Effect of Currency Unions on Growth", draft, Harvard University and University of California, Berkeley, May 2000.
9. The U.S.-Caribbean Act is Title II of the Trade and Development Act of 2000, which also extends unilateral preferences to sub-Saharan Africa, renews the generalized system of preferences, and extends trade adjustment assistance programs.
10. A leading exponent is Robert Pastor, Lessons from the Old World for the New: The European Union and a Deeper, Wider American Community, draft manuscript, Institute for International Economics, March 2000.
11. Under a retorsion policy, Mexico and Canada would go through the procedural motions of imposing an antidumping duty, but suspend application so long as the United States brings no new cases. When the United States imposes new antidumping duties, Mexico and Canada would simply dip into the inventory of their own approved cases, and start collecting duties.