North American Free Trade Agreement

The North American Free Trade Agreement created a preferential tariff area among the United States, Canada, and Mexico beginning on January 1, 1994. However, the drive for regional economic cooperation had begun as early as 1851 with bilateral free trade negotiations between the United States and Canada. A free trade area involving the United States and all of Latin America was advocated by U.S. secretary of state James Blaine in 1881.

The first successful effort, however, was the landmark 1965 agreement that allowed duty-free trade in automobiles and original equipment parts between the United States and Canada. The resulting explosion of trade in the auto sector–from $625 million in 1964 to over $40 billion (about a third of total U.S.-Canadian trade) by 1984–motivated the Canada-United States Trade Agreement (CUSTA), which expanded free trade to most sectors of the economy beginning in 1989. Most of CUSTA’s provisions were retained in NAFTA, which took effect in 1994 after ratification processes in all three countries revealed considerable public uneasiness over issues commonly associated with the dilemmas of trade.(10)

Although some of the motivations for CUSTA/NAFTA parallel those of the EU, both their provisions and the institutional structures that support them are vastly different. NAFTA is indisputably an economic agreement, lacking both the broader social and political sweep of the EU–it contains nothing resembling the EU’s Social Charter, for example–and its more ambitious long-term goals for common foreign and defense policy. Thus, NAFTA has no parallel to the EU’s web of executive, legislative, and judicial institutions, nor to its elaborate mechanisms for citizen representation. More narrowly yet, NAFTA is principally a trade agreement with only limited provisions concerning investment and none addressing the monetary arrangements and economic policy coordination that are such a prominent part of the EU.

The core of NAFTA consists of a phased elimination of tariff and most nontariff barriers over ten years with a few sectors having a fifteen-year transition period. The remaining elements of NAFTA qualify this liberalization and provide a sparse institutional structure to implement the agreement and resolve disputes that arise under it. 

NAFTA attacks tariffs, but it does not prevent other barriers to trade such as subsidies and the procurement practices of governments. Some of these barriers pose the now familiar dilemma of competing values: Policies designed for other purposes–even Canada’s government-sponsored national health insurance and America’s defense-contracting practices–can be seen as trade barriers because they confer a competitive advantage on some firms. Negotiations on such matters were difficult because the structure of protection is so different across these countries, with the United States objecting principally to Canadian subsidies and Canada protesting that the United States used its trade-remedy laws to stifle legitimate competition.

Liberals also complain that NAFTA does not remove the barriers to movements of capital that prevent the most efficient combination of all factors of production. For example, a government review board is still required to approve foreign investment in some sectors of the Canadian economy, and parts of the energy sector remain off limits in both Canada and Mexico. NAFTA also contains no provision to control fluctuating exchange rates, which can distort trade because an undervalued currency will “tax” imports by making them more expensive (because it makes foreign exchange more expensive) and “subsidize” exports by making them cheaper. During the CUSTA negotiations, the National Association of Manufacturers and the AFL-CIO contended that the undervaluation of the Canadian dollar acted as a protectionist measure, but exchange rates for the Mexican peso, which have fluctuated wildly, are potentially even more unsettling. For example, the value of the peso declined 33 percent in relation to the dollar during one week in December 1994, wreaking havoc in accurately pricing imports and exports. One year after NAFTA came into effect, the peso had declined by 43 percent; at the fifth anniversary, the peso had lost 70% of its pre-NAFTA value.

If NAFTA is flawed from the standpoint of liberals, its limitations are even more alarming to those concerned about the issues that arise from trade dilemmas. Provisions to deal with those concerns, which are prominent in the EU, are largely missing from NAFTA, in part because the motivations for regional integration were somewhat different in these two cases.

Motivations for NAFTA

Like the EU, NAFTA is the product of multiple motivations, the importance of which differed across the three countries. Both Canada and Mexico were driven principally by liberal incentives, emphasizing the value of economic growth over equality, security,and sovereignty. However, NAFTA promised efficiency gains associated with Ricardian comparative advantage that amounted to less than 1 percent of GNP for Canada. Relatively few areas of factor endowment-based comparative advantage remained unexplored because the American and Canadian economies were structurally similar and already largely open. For example, nearly 90 percent of U.S.-Canadian trade faced tariffs of less than 5 percent even before CUSTA. The liberalization that produced trade expansion among EU members began from much higher levels of protection.

However, reminiscent of the ECSC’s effect on smaller European countries, CUSTA/NAFTA offered Canada gains from economies of scale estimated at nearly 10 percent of GNP. Furthermore, because the agreement restrained U.S. trade-remedy laws, which produced forty cases of countervailing duties and antidumping sanctions between the United States and Canada from 1980 to 1987, Canadian firms can now exploit these economies of scale without fear that an economic downturn or a political campaign will trigger a disastrous protectionist turn in the United States. Such benefits were thought to be even more significant for Mexico because its smaller market ($214 billion compared to Canada’s $572 billion) offered fewer opportunities for large-scale production. Mexico also would seem to benefit more from Ricardian gains from trade even though before NAFTA its exports faced an effective trade-weighted tariff rate of only 3.5 percent in the United States (plus NTBs equivalent to another 1.3 percent).

Mexico’s principal motivation, however, was to improve industrial productivity both by exposing Mexican business to foreign competition and by encouraging foreigners to invest in Mexico. The Mexican economy had stagnated, especially during the 1970s and early 1980s, under the Mexican Partido Revolucionario Institucional (PRI), the ruling party for more than three-quarters of a century. The PRI’s economic approach, said to constitute a third way between capitalism and socialism, had featured an activist state, sharp restrictions on foreign investment, and extremely protectionist trade policies. For example, in June 1985, Mexico’s average tariff rate was 23.5 percent, import permits were required (and usually rejected) for products constituting 92.2 percent of tradable output, and official prices bound 18.7 percent of products. By the late-1980s, the PRI had undergone a revolution in economic policy, which came to emphasize privatization (selling 1,000 of the 1,200 state-owned companies, including the national airlines and the telephone company); budget deficit reduction (from 16 percent of GDP to under 1 percent); elimination of government price fixing; inflation reduction (from over 200 percent to under 30 percent per year); and import liberalization (by December 1987, tariffs averaged 11.8 percent and only 25.4 percent of goods required import permits).

NAFTA became the symbol of that revolution because it lent credibility to such a marked departure from historical practice, even though more liberalization occurred before NAFTA than was expected to follow its implementation. In particular, NAFTA encourages foreign investors to regard liberalization as permanent because it binds Mexico under international law to an agreement also enforced by the power of the United States. Otherwise, they would not risk a return to the old policies that could make their investment unprofitable. Without an influx of foreign investment, capital from domestic sources would be inadequate to fuel the growth made possible by Mexico’s cheap labor force and direct access to the American market.

Judging American motivations is more difficult because the liberal gains that dominated the calculus of both Canada and Mexico were expected to be much smaller for the United States. Because of its much greater size, any gains in access to the markets of its nearest neighbors would have a negligible effect on the American economy: In 1992, total trade with Canada and Mexico amounted to only about 2 percent of U.S. GDP. Obviously, the gains from economies of scale must be tiny, and reducing already low trade barriers promised little improvement in efficiently allocating resources.

These judgments were borne out by many macroeconomic models constructed to predict the effects of NAFTA on American output and employment. The gains were difficult to estimate, but even the most optimistic assessment foresaw a positive U.S. trade balance with Mexico of only $7-$9 billion annually with a net increase of only 170,000 U.S. jobs, a little more than one-tenth of 1 percent of the U.S. workforce. The corresponding efficiency gains would be under $2 billion annually in an economy of more than $5,500 billion. These gains would have been so small that in a dynamic economy we wouldn’t have been able to verify them even after the fact. As it happened, these predictions of a $7–$9 billion U.S. trade surplus with Mexico were entirely wrong; rather the U.S. ran a deficit of about $20 billion per year in its trade with Mexico in the late 1990s and from $20-$40 billion per year with Canada.

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