Your research paper for the “economic policy brief” considers the historical and policy contexts for a specific country. You consider the economic development history and important economic and politi

LO 13.2 Explain when purchasing power parity estimates of income per person are superior to the alternatives, and when they are inferior.

LO 13.3 State the reasons why Mexico and Canada sought free trade with the United States.

LO 13.4 Not for Di str ib u tio n Dem ogra p h ic a n d E co n om ic C hara cte ris tic s o f No rth A m eric a Table 13.3 gives an idea of the size of the NAFTA region. Income per capita is measured in two ways: in U.S. dollars converted from Canadian dollars and Mexican pesos at market exchange rates, and in dollars measured in terms of purchasing power parity (PPP) . The PPP adjustment enables us to know internal purchasing power, which is defined as the amount an average income can buy inside the country where the income is earned when it is measured in terms of the cost of a similar basket in the United States. Income per capita at market exchange rates is the external purchasing power of an average income. The differences between internal and external purchasing power are more easily understood with an example. Looking at Table 13.3 , an average Mexican income can buy goods and services in Mexico that would have a value of $17,534 in the United States. This is the internal purchasing power of an average Mexican income. The external purchasing power is $9,009, which is the value of the goods and services an average income can buy if it is spent in the United States. The numbers tell us that on average, goods and services cost more in the United States than in Mexico. The PPP concept adjusts for that fact and lets us make international comparisons of income based on similarly priced baskets of goods and services.   Not for Di str ib u tio n Table 13.3 Population and GDP for the NAFT A Region, 2015 Country Population (Millions) GDP (US$, Billions) GDP per C apita (US$) GDP per Capita (PPP) Canada    35.8   1,552.4 43,332 45,553 Me xico  127.0   1,144.3  9,009 17,534 Unit ed Stat es 321.6 17,947.0 55,805 55,805 Total 484.4 20,643.7 42,614 45,013 The NAFTA market is more than 484 million people and over 20.6 trillion in GDP.

Source: Data from International Monetary Fund, © James Gerber. The PPP adjustment is necessary in order to compare actual living standards, while the market exchange rates income is useful to know something about the ability of people to buy goods and services in the world economy. The two numbers are not equal because exchange rates are rarely in long-run equilibrium and because non- traded goods vary in price across national boundaries. For example, labor-intensive goods and services are inherently less expensive in Mexico where there is a relatively abundant supply of unskilled and semi-skilled labor.

As shown in Table 13.3 , the NAFTA region has more than 484 million people (2015) and over $20 trillion in combined GDP. This makes it slightly smaller in population than the 28 nations and 507 million people that make up the EU, and slightly larger than the EU’s estimated 2015 combined GDP of US $16.2 trillion.

With an average NAFTA-region GDP per capita (at market exchange rates) of over $42,000, it is a wealthy region by any standard. Not for Di str ib u tio n Can ad a– U .S . T ra d e R ela tio n s The United States and Canada have the largest bilateral trade relationship of any two countries in the world, with two-way merchandise goods and services trade in 2015 of more than $671 billion. This large sum is due to a shared border, a common historical background, and a similar culture, but it is also the result of three stages of integration over the last four and one-half decades. Beginning with the Auto Pact of 1965, followed by the Canada-U.S. Free Trade Agreement (CUSTA) in 1989, and the NAFTA agreement in 1994, Canada and the United States have taken advantage of their proximity to foster a set of mutually beneficial trade ties that focus on natural resources and intra-industry trade, particularly in the auto sector.

The Auto Pact of 1965 removed barriers to trade that previously forced the major U.S. firms to set up separate plants in Canada where they were unable to capture the full economies of scale essential to the car industry. By combining their production in the United States with their Canadian plants, General Motors, Chrysler, and Ford were able to produce for a single combined market. Before the agreement, Canadian plants produced solely for the Canadian market; after the agreement was implemented, they were suddenly more productive, as they could specialize in particular car models and increase their production runs to serve both the United States and the Canadian markets. Trade in both directions increased substantially, and productivity levels in Canadian plants, which were 30 percent below U.S. levels, rose dramatically.

By the 1980s, the car industry was integrated, but several new problems became apparent. Both the United States and Canada began to feel the rise of emerging markets in Asia, and Japan’s inroads into the U.S. auto market, steel, and consumer electronics were troubling as this seemed to indicate a loss of competitiveness in many U.S. and Canadian firms. Furthermore, the United States began to use antidumping and countervailing duties more often along with a new set of quotas administered under voluntary export restraint (VER) agreements. The latter were not voluntary in practice but worked the same as quotas in limiting foreign imports to a set level. The most important affected industry was the Japanese car market.  Not for Di str ib u tio n From the perspective of Canada’s leadership, growing U.S. protectionism and rising Asian manufacturing competitiveness were troubling signs because Canada is very dependent on the United States as an export market and as a source of imports. One solution to these pressures was to create FTA with the United States. This solution locked the United States into an international agreement that required it to keep its market open and, at the same time, put pressure on Canadian manufacturers to make changes to become more competitive.

The CUSTA was ratified in 1988 and implemented in 1989. CUSTA’s impacts were more or less as expected. Between 1989 and 1994, Canadian exports to the United States grew 55 percent ($47 billion increase), while U.S. exports to Canada grew 46.6 percent ($36.5 billion increase). In percentage terms this growth is not quite as rapid as the period before and after the implementation of the Auto Pact, but given that trade was already at a high level in 1987, a 50 percent increase represents an enormous volume of trade.

The debate over U.S.–Canadian free trade was low key and dispassionate in the United States. In Canada, however, a heated public discussion erupted when it was announced that the United States and Canada were negotiating an agreement. The opponents of the trade agreement feared that (1) Canada might not be able to compete with U.S. firms, which had the advantages of economies of scale; (2) expanded trade might force Canada to jettison many of its social programs; and (3) Canadian culture might come to be dominated by the U.S. news, information, arts, and entertainment industries.

The issue of Canadian competitiveness was largely one about the need to gain economies of scale and to increase productivity through organizational or technological changes within firms. For the most part, the real issue for a high- income, industrialized country such as Canada is the length of time over which the changes can be expected to occur, and not whether firms are capable of competing.

The Canadian opponents of CUSTA also argued that it would erode Canada’s social programs. For many citizens, Canada’s more extensive social programs, such as universal health care and more developed income maintenance programs, are part of a national identity that make Canada unlike the United States. The opponents ofNot for Di str ib u tio n CUSTA argued that the intensification of competition with the United States would undermine these social programs and dilute the difference between the two countries. They reasoned that social programs would be cut in order to reduce business taxes and make Canadian firms more competitive. Given that taxes are one component of business costs, and that in some cases, there are offsetting reductions in cost elsewhere, and it was incorrect to view a trade agreement with the United States as a threat to social programs. In the case of health care, for example, it makes more sense to argue that the United States’ system is at a competitive disadvantage, because the cost of hiring workers is raised when they must be provided with health care benefits by their employer. In Canada, by contrast, health care coverage is universal and is paid for out of general government revenues and individual taxes.

The final and most contentious issue from the Canadian point of view was the possibility of U.S. cultural domination. A very wide spectrum of opinion, including both opponents and proponents of expanded free trade, argues that the combination of Canada’s smaller population and its proximity to the United States will destroy its national identity if it allows completely free trade in the cultural industries. These industries include music in all of its venues, as well as radio, television, newspapers, publishing, magazines, drama, cinema, and painting. Under the rules of CUSTA, Canada is allowed to protect its national identity by imposing quantitative restrictions on imports of “cultural products.” In most cases, the rules allow Canada to impose domestic content requirements on television, radio, and theater. For example, the content requirements make it illegal for a radio or TV station to play content originating in the United States twenty-four hours a day.

Cable TV companies give preferences to Canadian-based TV networks, and there are national rules that favor Canadian theater companies, artists, and writers.Not for Di str ib u tio n Mex ic a n E co n om ic R efo rm s From the 1950s until the onset of a crisis in 1982, Mexican per capita growth averaged 3.3 percent per year in real terms, an impressive record that doubled living standards approximately every generation. This long boom in Mexico’s growth occurred under a set of trade policies called import substitution industrialization (ISI) that target the development of manufacturing through support for industries that produce goods that substitute for imports. As the leading economic development strategy throughout much of the world from the end of World War II until the mid-1980s, ISI policies prescribed industrial policies for goods production, beginning with simple consumer goods such as food and beverage, textiles and apparel, furniture, and footwear; and advancing through more complex consumer goods such as household appliances; and into industrial goods such as generators, pumps, and conveyors. This was to be followed by the development of more sophisticated industrial goods as countries moved up the ladder of comparative advantage, gaining manufacturing experience and changing their endowment of capital and labor skills. The tools employed by ISI policy included industrial support policies of tax breaks, low-interest loans, subsidies, occasional nationalization, and high protectionist barriers.

A major weakness of ISI policies is that they discriminate against exports. They do this by raising the rate of return for firms that produce for the domestic market where they have high protectionist walls and can charge higher prices while facing little or no competition. This also hurt Mexico and other ISI economies in the long run because it reduced the incentive to innovate or make product improvements, given that there was limited competition. With higher rates of return in the production of import substitutes, labor and capital were drawn out of the export sectors and into production for the domestic market. Consequently, when a decade of poor macroeconomic management in the 1970s came to a head in the 1980s, Mexico found itself deeply in debt and with limited capacity to export.

The debt crisis that began in Mexico in August 1982 was the result of a series of factors. From Mexico, the debt crisis quickly spread to the rest of Latin America, where similar policies had resulted in poor macroeconomic management and the accumulation of a large amount of debt. This period came to be known as the Lost  Not for Di str ib u tio n Decade and is discussed in more detail in Chapter 16 on Latin America. In Mexico, as in most countries, the underlying causes of the debt crisis were heavy borrowing from foreign banks, weak tax systems, and rising world interest rates that made debt service more expensive. Mexico had discovered new oil fields in the 1970s, and borrowing was encouraged by the belief that the price of oil would rise forever and along with it, the country’s ability to service ever-increasing amounts of debt. When oil prices began to fall in the early 1980s, the Mexican government’s oil revenue began to decline, just as its interest payments on the money it had borrowed were going up. These factors were intensified in their impacts on the Mexican economy by the fact that several decades of ISI policies had weakened the export sector (other than oil, which received special treatment). Weak export performance reduced the capacity to earn dollars that might be used to make payments on foreign debt. By August 1982, Mexico had exhausted its reserves of foreign currency and could no longer pay its debts. This triggered the onset of the debt crisis, which ultimately dragged on from 1982 until 1989.

The solution to the debt crisis required multiple policy changes. In the 1980s, Mexico privatized many firms that had been drains on the federal budget (938 were privatized between 1982 and 1992), brought its federal budget under control, reduced its restrictions on foreign direct investment in the country, and began to open its market to greater competition. In 1986, Mexico joined the GATT and in 1989, President Carlos Salinas proposed an FTA with the United States. Salinas had two goals in mind. First, he wanted to solidify his reforms in an international agreement. Before the political reforms that occurred in the late 1990s, Mexican presidents were granted extensive autonomy and authority. A more protectionist president could very well overturn the reforms that he and his predecessor (Miguel de la Madrid) had implemented; but if they were embedded in an international agreement, it would be much harder. Second, Salinas wanted to attract more foreign capital to increase the low domestic savings in Mexico. More foreign investment in Mexico would spur growth, while greater access to the large U.S. market would be an incentive for investors to build manufacturing plants in Mexico.  Not for Di str ib u tio n The No rth A m eric a n F re e T ra d e A gre em en t NAFTA was ratified in 1993 and took effect on January 1, 1994. Trade flows increased significantly, but they had been growing before implementation, partly in anticipation of an agreement.

The first important feature of NAFTA is that most forms of trade barriers came down. Because the United States and Canada were relatively open economies with few trade barriers, most of the change came on the Mexican side. For example, between 1993 and 1996, average U.S. tariffs on Mexican goods fell from 2.07 to 0.65 percent. By contrast, Mexican tariffs on U.S. goods fell from 10 to 2.9 percent. These reductions in tariffs under NAFTA were a continuation of the reduction in trade barriers that began in the mid-1980s. Between 1982 and 1992, the percentage of Mexico’s imports that required import licenses from the government declined from 100 to 11 percent, and tariffs fell from an average level of 27 to 13.1 percent. By 1994, Mexico’s economy was substantially open to the world.

Some tariffs and investment restrictions on each country’s cross border investment were eliminated immediately, but in many cases there was a variable period of phasing out tariffs and investment restrictions. The phase-out period for these remaining tariffs and investment restrictions varied from sector to sector. In cases where there was expected to be significant new competition, industries were given a longer period to prepare themselves because each country wants to avoid a sudden disruption of its economy even as it wants gains from trade.

A second feature of NAFTA is that it specifies North American content requirements for goods subject to free trade. To qualify for free trade or the reduced tariff provisions of the agreement, a specified percentage (usually 50 percent) of the value of the good must be made in North America. The purpose of local content requirements is to prevent non-NAFTA countries from using low tariffs in one NAFTA country to gain access to all three. Most trade economists dislike these provisions because they increase the likelihood of trade diversion. Production of inputs in lower-cost, nonmember countries could be reduced if firms move their operations to NAFTA countries in order to meet the content requirements—as happened in the apparel industry, for example. Firms moved from the Caribbean toNot for Di str ib u tio n Mexico, even though Mexico was not the lowest-cost producer. Mexico’s exports to the United States paid zero tariffs, so goods produced there could sell for less than goods produced in lower-cost countries and subject to high tariffs when entering the United States. Nevertheless, content requirements were politically necessary in order to pass the agreement in Canada and the United States.

A third feature of NAFTA is that it set up three separate dispute resolution mechanisms, depending on the source of the disagreement. Individual chapters cover disputes related to dumping and anti-dumping duties; treatment of foreign investors by national policies, called investor-state disputes ; and a third dispute resolution mechanism for general disputes. Each of these areas is separate from the consultation mechanisms for disputes over labor and environmental standards, which are a fourth significant feature of the agreement. NAFTA itself did not contain language regarding labor and environmental standards or concerns, but two side agreements were ratified and implemented at the same time as the trade agreement.

These are the North American Agreement on Labor Cooperation and the North American Agreement on Environmental Cooperation . The labor and environmental side agreements, along with the investor-state dispute resolution mechanism, have served as frameworks for most of the subsequent FTAs negotiated by the United States. Each of these has its supporters and its detractors and will be considered in more detail in the following discussion of the new trade agreements signed by the United States.   Not for Di str ib u tio n Tw o NAF TA -S p ecifi c I s su es A number of highly contentious issues arose during the NAFTA debate, as alluded to in the previous section. Some of the issues are specific to NAFTA, and some apply to all or nearly all trade agreements. Labor and environmental standards, relations between foreign investors and national governments, and intellectual property rights enforcement are general controversies, but they are also issues where NAFTA has served as a model for the design of trade agreements with other nations ( Table 13.2 ). These issues are discussed later in the chapter. Two specific issues that pose significant barriers to NAFTA’s deepening are immigration and the ongoing drug violence in Mexico.

NAFTA did not provide any guidance on immigration policy. Because it is a free trade area and not a common market, there is no provision for the movement of labor, except some categories of business people, nor is there any discussion of such a provision. In most contexts, a free trade area without immigration provisions is the norm, but in the context of U.S.–Mexico relations, it is a problem. Over the last four decades, the flow from Mexico has been the largest wave of immigration from a single country to the United States in U.S. history. Mexican migrants in the United States numbered more than 11.7 million in 2014 and were 28 percent of all immigrants. Researchers estimate that just over one-half of the Mexican immigrant population is unauthorized to be in the United States. Migrants go to the United States for the usual reasons: jobs, income, and family reunification. They also leave Mexico for the United States for specific reasons: proximity, the 2,000-mile-long border that is impossible to close completely, and a lack of jobs and opportunity in their home country.

The unprecedented wave of migration has declined dramatically in recent years, as more Mexicans leave the United States than arrive. This trend began around 2005 or 2006 and has at least three factors behind it. One, the border has become harder and more dangerous to cross. Much of it is desert wilderness with extremely rugged conditions that are made more severe by the growth of drug violence and the targeting of migrants by criminal gangs and drug cartels. Two, the political and economic environment of the United States is more difficult. Jobs are harder to find since the recession of 2007–2009, and throughout the border region, anti-immigrant Not for Di str ib u tio n groups and politicians have created an aggressively unwelcoming political environment. Three, and most significant for the long term, the demography of Mexico is changing in ways that are reducing the number of potential migrants. In 1960, the average Mexican woman could expect to have 7.3 children during her lifetime. By 2009, the number had fallen to 2.4, barely above population replacement levels. The decline in childbirths leads, with a lag, to a decline in the growth rate of the young adult population and the number of potential migrants. In sum, between 2005 and 2010, the number of people born in Mexico and living in the United States did not increase, as new entrants fell to the same level as the number leaving the country.

A second issue of grave concern in the NAFTA region is the rise in drug violence in Mexico. This is a very contentious and tragic issue with no consensus on needed policy changes, but with a continuing loss of life, mostly in Mexico and mostly related to the violence of transporting and selling illegal drugs. This issue has far more than trade implications because it concerns law enforcement, medicine, public health, economic well-being, civil liberties, and other areas. Currently and for many years past, both in Mexico and the United States, the discourse is dominated by politics. In 1969, President Nixon declared a “national war on drugs,” and nearly fifty years later, similar policies are in place, even as it is hard to show positive results from the war and as many tens of thousands of people have been murdered as a result of drug-related violence.

The violence in Mexico is a shared responsibility of the United States and Mexico because U.S. demand for illegal drugs generates the enormous profits for drug cartels that are used to corrupt Mexican judges, politicians, and police forces. There is no consensus on the solution to this dilemma. Classical arguments for legalization assert that making drugs illegal only forces them underground, where they are still available and provide profits to organized crime and incentives to use violence to settle disputes. Legalization proponents point to the problems of corruption, health and safety issues, and challenges to civil liberties as additional negative spillovers from the attempts by the authorities to enforce the laws. Counter-arguments are that addiction is likely to increase if drugs become more available or that it is immoral to condone drug usage by making it legal. While there is very little agreement, politicians in Mexico and the rest of Latin America are beginning toNot for Di str ib u tio n vocally challenge the U.S. lead in the war on drugs and have begun calling for new strategies—particularly ones that focus on demand reduction and the public health aspects of drugs instead of focusing solely on supply elimination.Not for Di str ib u tio n Case S tud y Ejidos, Agricultur e, and NAFTA in Mexico The majority of Me xico’s farmers work on a type of collective farm called ejidos. Ejido members can farm their individual pieces of land as independent farmers, planting what ever crops they choose, and their children can inherit the land, but they cannot sell the land and they cannot rent it out t o someone else. In theor y, they either farm it or lose it. The first ejidos were created about a decade aft er the Mexican Revolution (1910– 1917) and continued t o be formed until the constitutional r eforms of 1992.

Mexico’ s constitution put limits on the amount of land one person could own and gave landless agricultur al laborers the right t o petition the government for the e xcess land. The 1992 r eforms stopped the cr eation of new ejidos and cr eated a pr ocess for br eaking up existing ones by turning them into private landholdings. The r eforms do not require change, and most ejidos continue t o operate the same as they did befor e the reforms, although some have been privatiz ed and the land has been sold. At the same time that the government opened an avenue for buying and selling ejido lands, it cut many of the subsidies it had given t o small farmers. In the long run, changes in the level of subsidies for small farmers have been more impor tant than the new mark ets for ejido lands—and not always for the best.

According to the Me xican Census of Agricultur e, in 2007 there were 31,518 ejidos, with 4,210,899 members (including people living on the communal lands of indigenous communities). This is appr oximat ely 72–73 per cent of the labor force in agricultur e in Mexico. On aver age, ejido farmers t end to own less valuable lands, have smaller individual plots of land than mor e commercially orient ed farms, and pr oduce a disproportionat ely small share of the nation’ s agricultural output. This is not t o say that all ejido farmers are poor, but many of them lack access t o markets, to capital, and to t echnical knowledge that would allow the members t o earn a decent living. Not for Di str ib u tio n In 1992, Mexico rewrote the section of its constitution that allowed for the creation of ejidos. The administr ation of Mexico’s president, C arlos Salinas, ar gued that ejidos cr eated disincentives for investment in agricultur e, which k ept productivity low and contribut ed to rur al pover ty.

Some economists shar ed this view, but others wer e not so certain. The argument of the r eformers was that the lack of complet e ownership rights and ejidos’ small plot sizes inhibited the use of machiner y and other productivity-enhancing investments. Regar dless of the analytical correctness or incorr ectness of the causes of low productivity on ejidos, the vast majority of Me xico’s poor people lived in rur al areas and work ed in agriculture, often as members of an ejido. In 1992, about 25 per cent of the labor force was in agricultur e, but it produced only 9 per cent of GDP. One explicit purpose of the change in subsidies for small farmers and in ownership rights of ejido members was t o reduce the siz e of the agricultural labor for ce by creating incentives t o combine land holdings and to apply modern pr oduction technologies. In 1992, the undersecr etary of agricultur e stated that the goal was t o reduce the shar e of labor in agriculture from 25 per cent of the labor for ce to 15 per cent.

Eighteen years lat er, in 2010, 13.1 per cent of the labor for ce was in agriculture (compar ed to less than 2 per cent in the United States and Canada). The highest levels of pover ty continue to be concentr ated in rur al areas, and small-scale agricultur e continues to struggle even as lar ger, mor e modern and pr oductive farms do well. NAFT A opponents frequently blame the trade agreement for the difficult conditions on many ejidos and small farms, but Me xican agricultural policy plays a far lar ger role. Corn shows why . Corn is a dietar y staple for many Me xicans and the main cr op on many small farms. Under NAFT A, Mexico’s impor t duties on corn wer e scheduled to be phased out over a fift een-year period, but Mexico unilaterally cut tariffs ahead of schedule and incr eased imports from the Unit ed S tates, in par t to lower the price of corn for animal feed, incr ease the size of the countr y’s livest ock her ds, and e xpand the amount of animal protein in the diet of the aver age Mexican citiz en. Mexico’s larger and more commer cial farmers e xpanded their corn pr oduction along with the growth in impor ts, and the total amount pr oduced nationally incr eased.Not for Di str ib u tio n Nevertheless, small-scale farmers who oper ated at near -subsistence levels of production wer e badly hurt by this str ategy because it lower ed corn prices at the same point in time that the government cut subsidies t o small farmers.

NAFTA allows each countr y to subsidiz e its farms as little or as much as it chooses. Me xico provided appr oximat ely US $8.4 billion in farm suppor ts (subsidies) in 2014, but much of this went t o farmers who were relatively bett er off. That level of subsidies is equal t o 13.3 percent of the gr oss receipts of farmers. By way of comparison, in the Unit ed States, farm subsidies ar e 9.8 percent of farm r eceipts (see Table 7.3 ), accor ding to the Agricultur al Outlook of the Organization for Economic Co-oper ation and Development (OECD). The decision t o downsize the agricultur al sector was independent of the decision t o sign a trade agreement with the Unit ed Stat es and C anada, and clearly it did not tak e into account the plight of farmers who have few options other than a small plot of corn. Not for Di str ib u tio n