Trade in the era of NAFTA and GATT
The significance of the North American Free Trade Agreement (NAFTA) is best appreciated in light of the historical developments that laid the foundation for its adoption. Indeed, passage of NAFTA can be considered part of a historical tide traceable to an action taken in Great Britain 150 years ago: Parliament's 1846 repeal of major agricultural trade barriers known as the Corn Laws. Despite significant setbacks during periods of war, recessions, and depressions, the trend set in motion by Parliament so long ago continues today. This historical trend accelerated at the end of World War II with the creation of the General Agreement on Tariffs and Trade (GATT).
GATT is a multilateral, not regional, agreement. This implies that any tariff concessions between two GATT members must be applied to other GATT countries as well through the so-called most favored nation principle. This principle dictates that each member country impose the same tariff rates on all GATT members. Because GATT has about 120 member countries, it has had enormous influence in promoting freer international trade. This goal has been achieved, not only by eight rounds of tariff reduction negotiations but also by providing a mechanism to resolve trade disputes that might otherwise have resulted in the resumption of trade restrictions. Such a mechanism was reinforced as a result of the Uruguay Round Agreement, when the World Trade Organization (WTO) was created to provide an improved institutional framework for overseeing and enforcing the various parts of the GATT.
However, there is a very important exception to the most favored nation principle as GATT authorizes the formation of free trade areas or regional trading blocs among a subset of its members. Although many of these arrangements exist, the most important ones have been the European Union, whose origin goes back to the Treaty of Rome (1957); the Canada--United States Free Trade Agreement, concluded in 1988; and NAFTA, concluded in 1992. Whereas such regional arrangements are unlikely to achieve as deep a degree of integration as a multilateral arrangement, they have an important advantage in that negotiations take place between fewer and more like-minded members.
The conceptual developments underlying the movement toward freer trade were set forth in Adam Smith's The Wealth of Nations, published in 1776, and David Ricardo's lesser known (but more important) Principles of Political Economy, published in 1817. Ricardo's work laid the conceptual foundation for an understanding of free trade principles that until then had not been understood. Whereas Smith's work demonstrated that free trade between two nations tends to benefit both countries, Ricardo's work demonstrated that mutual benefit from trade would result even if two very dissimilar countries---such as an industrial country and a preindustrial one---engaged in free trade. These theoretical concepts contradicted previously accepted views that trade was a mechanism through which exporting nations gained at the expense of importing nations.
The basics of trade theory
Ricardo's theory of comparative advantage still provides the foundation for
all conventional international trade theory: Each nation gains by
specializing in the goods it produces most efficiently. However, in the
Ricardian context, efficiency is measured in terms of comparative efficiency
rather than absolute efficiency. To use a simple example, if the United
States were more efficient than Mexico in producing every single good, it
would nevertheless benefit by importing some goods from Mexico. The
greatest benefit would be gained by exporting those goods in which its
productive advantage is comparatively greatest and importing those goods in
which its advantage is comparatively least. The free play of market forces,
without guidance or intervention by the government, results in a pattern of
trade under which trading nations best exploit the principle of comparative
advantage.
Ricardo's theory was refined in the 1920s by two Swedish economists who formulated the factor proportions hypothesis, known as the Hecksher--Ohlin (H-O) theorem. According to the H-O theorem, nations enjoy a comparative advantage in producing goods that use their more abundant factors of production more intensively, and they import goods that use their scarce factors more intensively. Thus, the United States, which is abundant in capital, exports goods such as chemicals (the production of which is relatively capital intensive). Mexico and other nations with large populations of unskilled labor export goods such as textiles, which require relatively large amounts of unskilled labor.
A shortcoming of the H-O theorem as an explanation of trade patterns is its highly static nature. In its original formulation, it assumes that the pattern of comparative advantage (and factor endowments) is determined outside the model. In other words, the relative abundance of resources such as capital and skilled labor is simply taken as given and assumed to be unchanging over time. In reality, however, factors such as the size of a nation's capital stock and the skill of its people are affected by variables such as savings and investment rates as well as by educational and research expenditures. Thus, comparative advantage is a dynamic concept that can be shaped over time by various public policies.
In addition, the original H-O theorem was limited by the assumption that factors of production do not move across nations. Although this is true of some factors, such as land, it is not true of financial capital, technology, "human capital" (i.e., the increased productivity workers obtain through investing in formal education, informal training, and so on), or labor itself. Indeed, advances in transportation and communication technologies have greatly increased the mobility of these factors. Over the long term, such movements affect trade patterns too profoundly to be ignored in any complete analysis of international trade. Thus the movement of capital from the United States to Mexico and the increasing number of Mexican students attending U.S. universities are expected to affect the current trade patterns between the two countries. As a specific case in point, if U.S. investment in Mexico were to increase as a result of NAFTA, the stock of capital in Mexico would rise, leading to an increase in the Mexican production of chemicals and subsequently causing a decline in U.S. chemical exports to that country. The fact that investment measures have a direct effect on trade was recognized by both GATT and NAFTA.
Capital flows
Foreign direct investment (FDI) is defined as the ownership and control of a
business in a foreign country. It is distinguished from portfolio
investment, which is defined as the purchase of securities in a foreign
company solely to earn a financial return. FDI may take place for many
reasons. The main impetus to such international capital movements from
a developed to a less-developed country, however, is the difference between
the rate of return on capital in the two countries. If capital is scarce in
a less-developed country (e.g., Mexico, China, or India) yet relatively
abundant in a developed country (e.g., United States, Germany, or Japan), the
rate of return in the less-developed country will be higher than in the
developed country. This difference in rates will cause capital to be
attracted to the less-developed country. This movement of capital from the
developed country to the less-developed country will eventually decrease the
rate of return in the less-developed country, propping up the rate of return
in the developed country. When the rates of return are equal between the two
countries, there is no further incentive for capital to move. This statement
is valid when it is assumed that the same degree of risk attaches to
investment in each country or that the rates of return have been adjusted for
risk.
Although differences in rates of return on investment constitute the main reason for FDI, such investments are motivated by other important factors. These factors include less expensive land, lower labor costs, availability of raw materials, access to new markets, the potential to exploit monopolistic advantages, low transportation costs, freedom from government regulations, government incentives (such as tax abatement), diversifying political risk (through investment in several countries), avoidance of trade barriers, and greater suitability of internal contracting between the affiliates of the same multinational corporation to the dissemination of technology and processes that are specific to the firm.
To gain freer access to foreign markets, in the Uruguay Round of GATT the United States tried to push through rules that would allow capital to move more freely between countries. However, most other contracting parties were unwilling to accept such a sweeping change and agreed only to establish rules limited to investment measures that directly affect trade flows, the so called trade-related investment measures. Among these are local content requirements, which require investors to use a certain fraction of locally supplied inputs, and trade-balancing requirements that compel investors to export as much as they import. Such measures have been identified as inconsistent with GATT and will have to be progressively eliminated by all member countries.
The provisions on foreign investment in NAFTA are much more reflective of the United States' free-access approach than the Uruguay Round Agreement on trade-related investment measures. NAFTA and the Canada-United States Free Trade Agreement before it are based on two investment measures: the Right of Establishment and the National Treatment obligation. The Right of Establishment guarantees investors from any of the three NAFTA members the right to own business assets and engage in productive activities within the jurisdiction of the other countries. National Treatment requires that a foreign firm established in a host country must receive the same treatment as domestic firms under the host country's laws.
Under this agreement Mexico has agreed to allow foreign investors to increase significantly their purchase of Mexican assets within a 10-year period. Thus, Mexico's chemical and electric generation sectors will be opened to U.S. investment. However, the agreement also allows Mexico to limit foreign access to certain sectors of its economy for mainly social and political reasons. These limits are addressed in the Investment Chapter of the NAFTA (chapter 11) and in various annexes to the agreement (1). The restricted sectors include oil and gas exploration, production, and refining.
These provisions in no way ensure greatly increased investments among NAFTA members. The continued volatility of the Mexican peso and the related risk remain an impediment to such capital flows. If a company invests in a country whose currency devalues, the company will sustain a depreciation in the value of its assets within that country. Many U.S. firms have put investment projects on hold or have canceled them altogether as a result of the recent series of peso devaluations. Therefore Mexico must stabilize the peso if it is to realize the capital inflows anticipated with NAFTA.
The effects of trade barriers
In the United States and most other developed countries, trade barriers
protect domestic industries by limiting the volume of imports and raising
product prices above the international price levels. Because the
international price of a good or service generally reflects the costs of
producing commodities efficiently, trade barriers produce artificially high
prices and thus distort domestic production and consumption decisions.
First, the higher price of a protected good attracts resources from
unprotected and presumably efficient industries into protected and
inefficient industries. Thus, by insulating domestic producers from foreign
competition, trade barriers encourage inefficiency, the so-called
production distortion loss. Second, the higher price results in a decrease
in domestic consumption of the product, the so-called consumption distortion
loss. The total welfare loss to the nation imposing the tariff is
equal to the sum of the production distortion loss and the consumption
distortion loss. Consequently, if a tariff results in a loss to the nation
imposing it, it follows that this country will be better off if it
unilaterally lowers its tariff rate. Of course, this will not be apparent to
the producers who previously benefited from protection, because they will
suffer the effects of international competition.
Mexico apparently understood this, because it began to abandon its protectionist mode even before NAFTA was approved. For example, Mexico's average tariff on consumer goods fell from 60% in 1985 to less than 20% by 1992. Chile, a NAFTA candidate, preceded Mexico in adopting such policies. However, if unilateral trade liberalization enhances welfare, reciprocal or multilateral trade liberalization generates even greater welfare gains.
The first seven rounds of GATT reduced world tariffs on manufactured goods from an average of approximately 40% to about 5% today. With respect to chemicals, the post-Tokyo (seventh round) average tariff rate applied by all developed countries was 3.1%. The Uruguay Round (eighth round) moved the participants another significant step toward freer trade by slashing tariffs by about one-third on a wide range of products, cutting export subsidies, and replacing quantitative restriction by tariffs that are to be reduced over time. Further reductions in tariffs on chemicals were quite limited, because tariffs on these products were fairly low before the Uruguay Round.
Although NAFTA is only a regional agreement, its impact will likely be substantial. Canada and Mexico are the United States' first- and third-largest trading partners, respectively, and the three countries have a combined annual gross national product of $6 trillion---surpassing the European Union's $4 trillion. Its goal is to eliminate most tariffs among the three member nations over a period of 10 years. Quantitative restrictions, such as quotas and import licenses, will also be eliminated. With respect to energy and basic petrochemicals, NAFTA introduces free trade in crude oil, natural gas, electricity, uranium, petroleum products, petrochemicals, and oil field equipment. The agreement also allows trucking services across borders and for the customs requirements in Mexico to be gradually liberalized. This should greatly reduce the cost of transporting chemicals between the United States and Mexico, enhancing the volume of trade in chemicals and other goods between the two countries.
What about jobs?
During the months preceding passage of NAFTA, the effects on jobs became a
major political issue in the United States. Opponents argued that U.S.
workers would lose jobs to Mexico, whereas supporters were predicting that
freer trade would help to create jobs on both sides of the border. It is
clear now, as it was to most economists before adoption of NAFTA, that
microeconomic events such as the implementation of NAFTA exert no perceptible
long-run effect on employment, which is essentially determined by
macroeconomic conditions and policies. Thus, the removal of trade barriers
will probably have a limited impact on economic growth and employment but a
substantial one on the types of jobs available.
The H-O model predicts that trade will raise the price of the abundant factor of production. This is because the country abundant in unskilled labor will expand production of goods intensive in unskilled labor, causing the demand and the wages of unskilled labor to rise. Similarly, the country abundant in skilled workers will expand production of goods that use a lot of skilled workers, causing their wages to increase. However, not every worker or firm will benefit from freer trade. The symmetric effect is that the wages of low-skilled U.S. workers tend to fall as the United States produces fewer goods made by low-skilled workers in the face of rising imports of such goods from Mexico. In light of this tendency, it is rational for low-skilled U.S. workers to be opposed to free trade, despite the fact that the nation as a whole benefits.
What does the previous discussion imply about the impact of freer trade on the wages of workers employed in the chemical industry? Because the United States has a comparative advantage in producing specialty chemicals, the demand for highly skilled workers will likely increase as the chemical industry expands, causing the wages of these workers to increase. However, because industries employing low-skilled workers are likely to contract, those wages will probably fall. To the extent that the chemical industry also employs some low-skilled workers, their wages would also fall. The wage differential between the two types of workers in the chemical industry will probably increase.
Freer trade may have some impact in the long term on the migration of workers between the United States and Mexico. Because the wages of low-skilled Mexican workers will rise and those of their U.S. counterparts will fall, the incentive for Mexican workers to move to the United States will be reduced. In fact, free trade in goods can be seen as a substitute for the migration of factors of production and should be supported by those concerned by current migratory patterns.
Factoring in the environment
The relationship between the environment and international trade has only
recently occupied a place on the agenda of trade agreements. Whereas
environmentalists are mainly concerned about the so-called "race to the
bottom," industries and firms move to countries with lower environmental
standards to gain a competitive advantage. It is feared that this would put
pressure on countries that have high domestic environmental standards to
lower them. Whereas such an outcome is theoretically possible, there is no
evidence that such a race is taking place. Moreover, if the U.S. government
wants to protect the environment then it should require American firms abroad
to maintain the environmental practices they use at home rather than force
poor countries to adopt higher standards they cannot afford and which are
likely to reduce their ability to grow. Many companies already do.
NAFTA (or, more precisely, its environmental side agreement) is the first trade treaty that deals explicitly with the relationship between trade and the environment. In contrast, the drafters of the GATT make only vague references to the environment. The NAFTA environmental side agreement, known as the North American Agreement on Environmental Cooperation, binds the three countries to effectively enforce their own domestic environmental laws by providing an institutional framework for dispute settlement and the imposition of sanctions against a NAFTA country that fails to enforce its own environmental laws. In addition, NAFTA provisions on the environment require that no NAFTA country is to lower its environmental standards in an effort to attract investment.
Another reason to believe concerns about this race to the bottom are exaggerated is that these high standards may create incentives for the development of environmental technologies that can be exported to other countries as their demand for environmental protection increases. Mexican demand for such technologies will likely increase substantially, but the United States will benefit the most by exporting such technology, provided that the United States does not lower its own standards.
Expectations
Full implementation of GATT and NAFTA is part of a continuing trend toward
reduced trade barriers. Freer trade should allow the United States, which
already has an overall trade balance surplus in chemicals, to exploit more
fully its comparative advantage in specialty chemicals. Mexico, on the other
hand, will likely have a comparative advantage in a few commodity chemicals.
Obviously, the recent peso devaluations will serve to further enhance the
competitiveness of the Mexican producers.
Although there is considerable uncertainty as to whether and how GATT rules apply to many investment measures, NAFTA is characterized by far more extensive coverage of investment measures and strongly encourages increased capital flows among the member nations. NAFTA will allow U.S. firms to invest in certain sectors of the Mexican chemical industry. As a result, the North American chemical industry will be able to compete more effectively in world and Asian markets.
Acknowledgments
I thank Dr. Barry Wilbratte for reading the manuscript and offering helpful
suggestions.
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