TRADE THEORY

Would you characterize your country as afree-trader or protectionist country & why?
NAFTA: A Primer
Discussions concerning a proposed North American Free Trade Agreement (NAFTA) began in the early 1990s among the United States, Canada, and Mexico. The proposal called for phasing out trade tariffs among the three countries in order to open up their borders to regional free trade. Its design and approval were marked by contentious debate, especially in the United States under Presidents George H.W. Bush and Bill Clinton. NAFTA was signed in 1994; fifteen years later, it has been described by the New York Times as a politically charged symbol of the promises and perils of free trade. Currently, NAFTA encompasses about 440 million people and is one of the worlds largest free trade zones.

Background: What is Free Trade?

In a free trade scenario, the market determines who are the producers of certain goods and services, and who are the buyers. Theoretically, each country benefits from comparative advantage countries produce they can produce most efficiently and at the lowest costs, and buy from other countries what those countries can produce better or cheaper. The concept free trade is premised on the unimpeded flow of imports and exports. For most of modern economic history, empires and countries protected their own domestic producers and markets from imports by erecting trade barriers. Trade barriers can be in the form of:

Tariffs, which are taxes on goods imported from other countries that artificially raise the price of those goods and therefore make domestically produced goods more competitive. Subsidies, which are government grants paid to domestic producers so that those producers can charge less for their products, and therefore be more competitive. Tax breaks for domestic producers that lower their taxes and thereby decrease their costs.

Labeling and packaging requirements and standards for imported goods that are expensive for foreign producers to implement, and add a cost not borne by domestic producers. Import quotas which place limits on the amount of imports of certain goods allowed into a country.

In the absence of protectionist policies like those described above, truly free trade would result in a world where developed countries (such as the US and Canada) would buy their agricultural and basic manufactured goods from those countries that can produce them more cheaply (developing countries such as Mexico where land and labor are less expensive). Developed countries would then turn their attention to producing more technologically sophisticated goods and services that they can produce more efficiently with their educated workers, advanced infrastructure, and access to innovation. This theory is extremely compelling, but the worlds realities prevent the theory from being fully practiced. One reason is the persistence of protectionist trade barriers. Another is the impossibility of completely efficient economic planning. It is important to remember that free trade is not the same thing as fair trade. Fair trade implies a form of social justice factored into the exchange of goods and services. Fair trade goods such as coffee come with the assurance that the growth and production processes have been fair and equitable to the workers involved.

Globalization and Free Trade

Globalization has been marked by the movement of countries away from protectionist policies and toward free trade policies that allow more efficient movement of goods, services, capital, and people between countries. It is generally accepted that, in order to prosper in the modern economy, a country must be able to reach consumers and find suppliers beyond its borders. Free trade policies make this possible; these policies can exist at the bilateral (country to country) or regional level (where free trade blocs are created among numerous countries). The World Trade Organization (WTO) promotes worldwide free trade policies. (See the Trade Policy Section of the Global Poverty and International Development edition of the World Savvy Monitor for more information). Countries often enter into numerous, and even overlapping, free trade agreements. Mexico, the United States, and Canada maintain bilateral free trade ties with each other and many

other countries inside and outside of the Western Hemisphere in addition to participating in NAFTA. The regional free trade zone that is most often held up as the most successful in the world today is the European Union (EU), which currently includes 27 member countries.

Experts generally point to the EU as a model for harnessing the potential of both rich and poor countries on the continent through free trade, combining the cheaper labor of less developed countries with the technological know-how of more developed ones. EU mechanisms exist to mitigate the painful transitions associated with free trade, including aid and technological assistance among member nations. Each EU member nation provides government-funded social safety nets, such as pensions and health care, to further ease the pain associated with economic transitions. EU members also submit to a rigorous selection process that includes standards for governance and human rights.

NAFTA 15 Years Later: The Balance Sheet

NAFTA was supported in Mexico because intra-continental free trade, in theory, would allow the country to take better advantage of its greatest economic asset: its geographical proximity to the largest economy in the world, the United States, as well as to another economic power, Canada. Facilitating unfettered access to these countries was seen as critical to bringing the benefits of globalization to Mexico. Goods that could be produced more cheaply in Mexico could be exported to US and Canadian consumers; American and Canadian technology and investment would flow to Mexico. Accomplishments:

Trade among the three countries did, in fact, increase dramatically, 227% between 1993 and 2008, according to the World Bank. Trilateral trade currently accounts for $15.3 trillion in goods and services annually. Mexicos share of this trade, which had previously been dominated by US-Canadian trade, also increased dramatically. Mexicos imports from Canada rose 704%; its

exports to Canada rose by 482%. Mexicos imports from the US rose by 236%; its exports to the US rose by 440%.

Since the implementation of NAFTA, all three countries have experienced GDP growth. The US and Canadian economies each grew by 53%; the Mexican economy grew by 51%. (Remembering that percentage growth of larger economies like the US and Canada yields much greater absolute gains than percentage growth in an economy like Mexico they started at dramatically different levels, pre-NAFTA).

Disappointments:

The Mexican economy did not grow as much as expected. Inequality and poverty have persisted. Slow wage growth for workers continues to harm domestic consumption and overall domestic growth. Many had hoped that NAFTA would decrease immigration from Mexico to the United States by creating Mexican jobs. This has not been the case, with over 500,000 Mexican immigrants entering the US every year. Technological advances have come slowly to Mexico. Most industry is still in the low-value added sector, which means sophisticated parts are manufactured elsewhere and shipped to Mexico for assembly only. This results in only a small part of the profit from these goods remaining in Mexico. Mexican workers remain under-educated and under-trained, relegating Mexican industry to a less lucrative place in the global supply chain. Mexican agricultural exports have grown more slowly than anticipated, largely due to competition from large agricultural enterprises located inside the United States and protected by US government subsidies. Mexican farmers retain an advantage in crops that are hand-picked, such as avocados and strawberries, but many farmers, especially those producing corn, have been hurt by the dismantling of tariffs that protected them from cheap subsidized US imports. Some would say that the intensification of the drug war is to some extent linked to NAFTA opening borders to legitimate trade has also facilitated trafficking in illegal substances and guns.

Why the Disappointment Associated with NAFTA?

Examinations of what NAFTA has and has not done for the Mexican economy are plagued by misperceptions about what NAFTA is and what it is not. From the beginning, expectations for the trade pact probably exceeded what could realistically be accomplished. Internal factors within Mexico and unanticipated global

trends have also had an impact on what is often referred to as NAFTAs underperformance. Problems With the Pact:

Free trade can be painful, as competition eliminates some kinds of jobs. NAFTA lacks many of the cushioning measures for populations which would not benefit from globalization. These include social safety nets for the displaced and unemployed, as well as labor standards for workers. There are few provisions within NAFTA for the mediation of trade disagreements. NAFTAs focus is on eliminating tariff barriers; it neglects other protectionist measures. For example, US agricultural subsidies have gone unaddressed and continue to affect the competitiveness of Mexican exports. Implementation has been uneven. For example, a provision designed to allow Mexican trucks to deliver products in the US was rejected by the US Congress in early 2009. Both labor and environmental standards are largely missing from NAFTA, leading to unsafe working conditions in factories on both sides of the US-Mexico border and to environmental degradation in border towns where large populations have settled.

Problems Within Mexico:

NAFTAs failure to live up to Mexican expectations has a lot to do with Mexicos own internal economic policies. Instability characterized by swings between the ideological left (prolabor) and right (pro-business) have discouraged foreign direct investment and hampered macro-economic planning. Powerful oligarchs continue to call the shots in many sectors of the economy, interfering with the development of cohesive trade policies. (See the Inside Mexico: Economy section for more). Challenges in the mid-1990s, unrelated to NAFTA itself, led Mexico to get a late start in capitalizing on NAFTA. These included a debt and currency crisis, the assassination of a Presidential candidate, and the Chiapas uprising in the first years of the pact.

Mexicos lack of education infrastructure has largely kept it from being able to protect workers from free trade dislocations or to develop more lucrative higher-end manufacturing. The US and Canada have had a distinct edge in their capacity to retrain workers and move them into other industries harmed by Mexican competition. Mexicos lack of infrastructure has limited its ability to take advantage of NAFTA. With its population spread throughout the country and its infrastructure underdeveloped, mobility of labor and goods is compromised. Cities along the border are burdened by transient populations and poor urban planning associated with boom and bust trends. Moreover, poor infrastructure leads to bottlenecks in and around Mexico City through which nearly all Mexican goods produced in the South must travel.

Unanticipated Trends and Events:

The September 11, 2001 terrorist attacks on New York and Washington awakened security concerns at the US-Mexico border, and led to a tension between economic activity and counter-terrorism efforts. The Wilson Center has estimated that $9 billion is lost each year in USMexico sales and investment due to wait times at the now highly fortified border. Keeping trade moving while keeping populations safe from external threats has proven challenging. Chinas entrance onto the economic world stage has had perhaps the greatest effect on the promise of NAFTA for Mexico. Bilateral trade deals between all the NAFTA partners and China have resulted in stiff competition in the area of manufactured goods. Chinas factories employ more workers with better education levels, and enjoy more state promotion of industry than those in either the US or Mexico. Chinese imports account for job losses in the US and Mexico that are often wrongly attributed to NAFTA on both sides of the border. The current worldwide recession has highlighted the volatility associated with the global marketplace, and Mexico is suffering in numerous ways. Exports are falling in response to reduced consumer demand in the US, reduced US investment in the Mexican economy, and a steep decline in remittances from Mexican workers who have lost their jobs in the US. Add in the swine flu and its effect on tourism, and the Mexican economy is now facing its greatest challenge since the peso crisis in 1995.

How would you describe trade theory as it appliesto your country? What is New Trade Theory?
by Alex Tabarrok on October 13, 2008 at 10:33 am in Uncategorized | Permalink Congratulations to Paul Krugman on his Nobel. Here is a primer on one of Krugmans key contributions, New Trade Theory. Tyler has more links below. Ricardo showed that every country (and every person) has a comparative advantage, a good or service that they can produce at a lower (opportunity) cost than any other country (or person). As a result, production is maximized when each country specializes in the good or service that they produce at lowest cost, that is in the good in which they have a comparative advantage. Since specialization in comparative advantage maximizes production, trade can make every country better off. But what determines comparative advantage? In Ricardo it is the natural products of the soil, Portugal is good at producing wine and so England has a comparative advantage in cloth. Heckscher, Ohlin and Samuelson among others extended the model to show how factor proportions can determine comparative advantage countries with a lot of labor relative to capital, for example, will tend to have a comparative advantage in labor intensive goods production. Notice, however, that in the Ricardian model and its extensions the determinants of comparative advantage like geography and factor proportions lie outside of the model. New Trade Theory of which Paul Krugman can be said to be the founder, brings the determinants of comparative advantage into the model. Consider the simplest model (based on Krugman 1979). In this model there are two countries. In each country, consumers have a preference for variety but there is a tradeoff between variety and cost, consumers want variety but since there are economies of scale a firms unit costs fall as it produces more more variety means higher prices. Preferences for variety push in the direction of more variety, economies of scale push in the direction of less. So suppose that without trade country 1 produces varieties A,B,C and country two produces varieties X,Y,Z. In every other respect the countries are identical so there are no traditional comparative advantage reasons for trade. Nevertheless, if trade is possible it is welfare enhancing. With trade the scale of production can increase which reduces costs and prices. Notice, however, that something interesting happens. The number of world varieties will decrease even as the number of varieties available to each consumer increases. That is, with trade production will concentrate in say A,B,X,Y so each consumer has increased choice even as world variety declines. Increasing variety for individuals even as world variety declines is a fundamental fact of globalization. In the context of culture, Tyler explains this very well in his book, Creative Destruction; when people in Beijing can eat at McDonalds and people in American can eat at great Chinese restaurants the world looks increasingly similar even as each world resident experiences an increase in variety.

Thus, Krugman (1979) can be thought of as providing another reason why trade can be beneficial and a fundamental insight into globalization. Moreover, Krugman (1979) began the task of bringing the reasons for comparative advantage within the model. In that paper, Krugman also hypothesizes briefly about what happens when we allow migration within the model. Recall, that in Heckscher-Ohlin-Samuelson factor proportions explain trade patterns but are themselves determined outside of the model. When people and capital can move, however, factor proportions are themselves something to be explained. Krugman (1991) (JSTOR and here) brings increasing returns together with capital and labor migration and transport costs into one model. Krugmans (1991) model has become a workhorse of economic geography and international trade. The model is too complex to explain here but the reasons for that complexity are clear to see when everything becomes "endogenous" small initial differences can make for big effects. To minimize transport costs, for example, firms want to locate near consumers but consumers want to locate near work! Thus, there are multiple equilibria and at a tipping point the location decisions of a single firm or consumer can snowball into big effects. So Krugman has been a leader in introducing tipping points, network effects and thus the importance of history into international trade as well as into economics more generally.