Continental Drift: NAFTA and Its Aftershocks

The North American Free Trade Agreement (NAFTA) is a

symbol of Mexico's incorporation into the U.S. economy as a low-wage

manufacturing center. This economic integration will drive down wages,

employment, and living standards, while rolling back environmental regulations

in the United States as well as in Mexico. But NAFTA is only a symbol: the

low-wage approach to economic integration continues apace with or without NAFTA.

The treaty was mainly designed not to promote economic changes (which were

happening anyway) but to improve the domestic political fortunes of Presidents

Bush and Salinas. However, many Americans appropriately concerned about

declining labor and environmetal standards that result from integration with

Mexico have fallen into the trap of opposing NAFTA while giving less attention

to the underlying economic strategies followed by both nations regardless of the

treaty's formalization.

Consider the trading practices that have developed even without NAFTA. General

Motors is now Mexico's largest employer. Ford, Chrysler, and GM already own a

total of 64 plants in Mexico. Half a million Mexicans now work in some 2,000

border plants (maquiladoras) that export to the United States, paying

minimal tariffs, low wages, and little attention to environmental standards.

While not all these maquila jobs would otherwise move north of the border in the

absence of these advantages (some might move to Asia or the Caribbean instead),

clearly the maquila sector has displaced hundreds of thousands of American

assembly manufacturing jobs. Defenders of maquila manufacturing assert that

these plants create markets for American-made machine tools and unassembled

components. But an American machine shop gains nothing when the assembly plant

it supplies moves from Wisconsin to Mexico.

In 1989, American-owned transnational corporations added 48,000 new

manufacturing jobs at home, while they added 46,000 in Mexico. This investment

pattern cannot be attributed to the prospect of NAFTA--Mexico's President

Salinas did not make his surprise announcement seeking a free trade agreement

until 1990. American manufacturers already have sufficient incentives, without

NAFTA, to create all the jobs they can in Mexico. In Mexico's export sector,

labor productivity often equals that in the United States, while real wages have

declined nearly 50 percent since 1982. Following this dramatic decline, Mexican

wages are now substantially below Asian rates: by 1989, the average Mexican

manufacturing wage had fallen to 16 percent of the U.S. wage, while the

Singapore wage was 22 percent and the Korean and Taiwanese wages 25 percent of

U.S. rates.

Mexico's unions, controlled by the ruling party, help attract export firms with

solidarity pacts that, since 1988, have continued to hold wage increases below

the inflation rate. A recently announced pact continues this policy through

1993. This summer, a Mexican court upheld Volkswagen's discharge of 14,000

employees who repudiated a contract negotiated by the union's

government-sponsored leadership. In 1987, Ford Motor Company renounced its union

contract, discharged 3,400 Mexican employees, and then rehired them with a new

union contract at reduced wages and benefits. When workers protested in support

of dissident union leadership, gunmen hired by the official union shot workers

at random inside the Ford factory. Then 1,000 state police entered the plant to

enforce the new contract.

Mexico's industrial environmental regulations, on the books, are comparable

with those in the United States, but are rarely enforced. Despite President

Salinas's pledge that Mexico would stop attracting investment with lax

enforcement, the General Accounting Office last year examined six new

pollution-prone American factories in the maquila sector and reported that none

had obtained permits, required by Mexican law prior to operations, certifying

that waste disposal and pollution control systems are in place. NAFTA won't

change this. NAFTA contains bold provisions barring import to the United States

of a product that is dangerous to consumers' health or safety, like a child's

crib with sharp edges, but contains no provisions by which Americans can

challenge the import of a crib that is unsafe for the Mexican workers who

spray-paint it. Nor can we challenge a Mexican manufacturing process that

depletes the ozone layer by failing to spray in sealed chambers (like those

required in the U.S.). That's why a flood of Southern California furniture

plants moved to Mexico when air quality regulations were tightened in Los

Angeles and why they expect to continue manufacturing in Mexico after the treaty

is in place.



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In a remarkable leap of logic, NAFTA opponents

habitually warn of NAFTA's dangers by pointing to environmental devastation and

job loss that has already taken place. Since intentions to negotiate NAFTA were

announced, hardly a month has passed without highly publicized pilgrimages of

trade unionists, environmentalists, and Democratic politicians to the Texas or

California borders. There they highlight sewage and industrial effluent in the

Rio Grande, children working in factories that make clothes or electronics for

export, or Mexican workers' families storing drinking water in toxic waste

barrels.

The pilgrims' conclusion is invariably: reject a free trade agreement with

Mexico! It is surely a case of rushing to shut the barn door after the horses

have fled. Whether NAFTA is approved or rejected, the movement of industrial

employment from the U.S. to Mexico will continue. The trade-weighted average

American tariff on imports from Mexico is already too low (4 percent) to impede

this relocation.

Lurking behind the misleading debates about NAFTA is a much broader issue. Will

we pursue an approach to global commerce and Third World development that

defends wages in the industrialized countries while insisting that increased

productivity in the Third World translate into increased living standards so

that consumption can grow along with production? Or will we permit

liberalization, privatization, and deregulated competition to slash wages and

hence living standards in both regions? The former path requires debt relief,

expanded development lending, protection for "infant industries,"

increased labor and environmental regulation, domestic content rules, and above

all increased purchasing power in the Third World. The latter, laissez-faire

path, relies primarily on private capital and the natural tendency of

transnational corporations to seek the lowest possible labor costs. NAFTA needs

to be understood as a symptom of this broader problem, not as the problem

itself.


STEALING EACH OTHER'S CLOTHES

NAFTA opponents concede that job dislocation will continue with or without a

free trade pact. They claim, however, that particular provisions of the

agreement will accelerate job loss in vulnerable sectors--apparel, for example.

The U.S. and Mexico have an exhaustive agreement under the Multi-Fibre

Arrangement (MFA), with numerical quotas established for every conceivable

fabric and garment. The U.S. apparel industry has lost 300,000 jobs since 1978,

due to labor-saving technology and Third World imports. Apparel imports from

Mexico's maquilas have shot up from $360 million in 1986 to $844 million in

1991. If, critics charge, NAFTA supersedes the MFA and quotas are lifted, a

greater flood of imports will destroy many thousand more American jobs. In a

1987 Labor Department survey, 32 percent of apparel workers who lost their jobs

in plant closings or layoffs in the prior four years had still not found new

jobs. Surely, NAFTA opponents claim, apparel is a case where the barn door can

be slammed before it's too late.

Not so. MFA quotas for Mexican-assembled apparel are already meaningless. As

the U.S. has warmed to Mexico's economic reforms, quotas for Mexican apparel

have risen dramatically. While the MFA sets a 6 percent annual growth norm for

developing country exports, in 1988 the U.S. granted Mexico a 42 percent

increase in apparel quota. In 1990, many garment types were granted additional

25 percent growth while other categorical limits were abolished. A subsequent

pact negotiated in 1991 contained more big jumps. Our MFA agreements with Mexico

also increase quotas whenever Mexico approaches its ceiling--making the entire

quota system almost meaningless. In 1992, the Congressional Office of Technology

Assessment surveyed apparel exporters in Mexico and reported that "with one

exception, every apparel maker interviewed claimed that they could get all of

the quota they needed."

Yet even so, Mexico cannot count on apparel exports as a secure source of

foreign exchange. Mexico's free trade strategy can work only if Mexico has privileged

access to U.S. markets. But as "free trade" expands, Mexico's

competition with other nations for U.S. investment will become cutthroat.

Fighting with other nations for shares of a finite U.S. market, Mexico could

lose.

An indiscriminate worldwide free trade crusade along with a practice of using

American jobs as foreign policy pawns have led to quota concessions for other

nations, undermining advantages Mexico expects from favored status. President

Bush thanked Turkey (the world's ninth biggest apparel exporter) for its help in

the Persian Gulf by doubling Turkey's U.S. quota in men's trousers to 4 million

pairs a year. To encourage the breakup of communism in Eastern Europe, President

Bush increased apparel quotas for Poland, Hungary, and Czechoslovakia. We

supported the Aquino government in the Philippines by granting liberal apparel

quotas, and that nation's $500 million apparel export industry is now equal in

size to Mexico's.

When the Reagan administration worried about leftist politics in Jamaica, the

U.S. promulgated a Caribbean Basin Initiative that virtually eliminated quotas

for Caribbean apparel. From 1986 to 1991, while American apparel imports from

Mexico grew by 221 percent, imports from other Caribbean countries grew by 245

percent and are now four times the level of apparel imports from Mexico.

Guatemala's export sector, for example, has 70,000 apparel workers, up from

2,000 only eight years ago, and is now one-and-a-half times the size of Mexico's

maquila zone. In 1986, Guatemala, like Mexico, began an economic stabilization

program designed to attract exporters. Like Mexico, Guatemala used a combination

of currency devaluation and wage restraint to reduce labor costs in export

industries. As a result, Guatemala's apparel wages are now 20 cents an hour,

about one-fourth of Mexico's maquila apparel wage. Van Heusen is the largest

U.S. employer in Guatemala, employing 1,000 workers and exporting 20,000 shirts

a month. Guatemala's apparel exports to the U.S. rose from $22 million to $350

million from 1986 to 1991.

China is already the world's largest textile exporter, with capacity to

overwhelm every other nation's garment industry. While human rights issues have

lately tempered quota increases, China's apparel exports to the U.S. grew in the

mid-1980s by 19 percent annually. With or without NAFTA, Mexico's garment plants

will increasingly compete with Chinese exporters having lower wages and superior

productivity. In the context of worldwide trade liberalization, it is difficult

to argue that NAFTA's lifting Mexican MFA quotas will be a major cause of

continued devastation in America's apparel industry.


SOUTHERN HOSPITALITY

NAFTA really can't make trade any freer than it already is. NAFTA opponents

suggest, however, that the treaty will stimulate greater U.S. job loss by making

investment in Mexico more secure. Yet while the agreement contains additional

security for investment (guaranteeing, for example, the right to repatriate

profits) along with dispute resolution procedures that give U.S. capitalists the

property rights of their dreams (without the tort system they abhor), it is not

credible to argue that these new legal protections will stimulate vast new

investment in Mexico. American firms have shown no sign of withholding

investment in Mexico out of fear that property rights are not secure.

U.S. companies considering foreign investment are generally more wary of

exchange-rate risk than of political risk. But NAFTA establishes no currency

union or even coordinated monetary policy between the U.S. and Mexico, so the

treaty itself will not protect the dollar value of peso investments. The peso

has fallen from 25 to the dollar in 1981 to 3,100 to the dollar today, and more

devaluations are probable. Nonetheless, U.S. direct investment in Mexico

continues to grow at the rate of $2.5 billion a year. This flood of cross-border

investment continues because the primary purpose of manufacturing in Mexico is

export back to the United States. Devaluation may affect the paper value of

Mexican assets on American firms' books, but it also cheapens the cost of labor

and other Mexican inputs, enhancing export profits. U.S. investors' lack of

concern about future peso devaluation and their failure to press for monetary

coordination in NAFTA is perhaps the best evidence that, contrary to public

propaganda, these firms have little interest in selling to the Mexican market.

They don't care about the possible low value of sales in pesos. Only sales in

dollars matter, and a cheap peso helps that.

In truth, while Mexico is unlikely under any circumstances to get the $15

billion annually in foreign capital that rapid growth requires, no treaty is

needed to cement Mexican hospitality to U.S. investment. Without NAFTA, Mexico

has privatized banks, state enterprises, and agricultural land. It now permits

100 percent foreign ownership in even basic industries like cement, glass, iron,

steel, and cellulose. It has eliminated most domestic content rules and

abolished subsidies to once-protected industries. Indeed, the Mexican

government, in its desperate search for foreign capital, reinterprets

restrictions too politically charged for NAFTA to repeal. For example, NAFTA

fails to remove Mexico's constitutional prohibitions on foreign ownership of oil

reserves and on "risk contracts" (where royalty payments are

contingent on successful exploration). Yet the Mexican government now permits

risk contracts in all but name, labeling them "performance contracts"

where payments (not called royalties) to foreign firms reflect the rate at which

oil is pumped.

In short, if Mexico wants (or needs) to open its economy to foreign investment,

it does not require U.S. treaty consent to do so. And if those who are less

hospitable to U.S. influence someday come to power in Mexico, NAFTA can be

repudiated with little difficulty. The U.S. army, the International Monetary

Fund (IMF), the World Bank, and international capital markets offer much greater

disincentives to radical policy change than does a paper treaty.

If NAFTA's opponents exaggerate its costs, NAFTA

proponents also engage in flights of fancy in touting the treaty's benefits.

They may acknowledge that relocation of American manufacturing to Mexico will

continue. But they also allege that the job losses will be offset by gains in

U.S. export industries that will now find new market opportunities with Mexico's

"80 million consumers."

Leading the pack of economists arguing a case for NAFTA have been MIT's Rudiger

Dornbusch and the University of Texas's Sidney Weintraub. Each argues that as

Mexican industrialization proceeds, not only will U.S. consumers benefit from

the lower cost specialization ("comparative advantage") of trade

between the two nations, but competition in Mexico for scarce skilled and

semi-skilled manufacturing labor will increase demand for labor, thus raising

wages. Economies of scale (from serving U.S. markets) and greater capital

investment in technology will lead to increased Mexican productivity and also

higher wages. Then Mexican purchasing power will grow, along with Mexicans'

appetite for U.S. imports. As Dornbusch testified before a congressional

committee, "Mexican wages will rise, the internal market will expand, and a

good part of the extra demand will spill over to the U.S. in orders for our

export industries."

It is true that U.S. firms are selling more toothpaste, diapers, cameras,

clothing, and other consumer products in Mexico since Mexican import

restrictions were dropped and tariffs lowered. Yet expectations that such growth

can continue are unrealistic. The Mexican middle class is tiny; relatively few

Mexicans can shop for any but the most basic U.S. consumer products. Unless

incomes of Mexican workers increase dramatically, the Mexican consumer market

will provide little long-term benefit to most U.S. exporters.

Mexican incomes are unlikely to grow substantially. Mexico has so many

unemployed and underemployed workers that labor markets will not tighten to

cause a general increase in wage levels. Mexico needs a 6.5 percent annual

growth rate just to provide employment for one million new work force entrants

each year, making no dent in the present labor surplus. Yet even optimistic

observers hope for less growth than that. The Brady Plan to "solve"

Mexico's debt crisis assumed future Mexican growth of 4 percent, assuring that

the labor surplus would grow. (In 1991, Mexican GDP grew by 3.6 percent, and

1992 estimated growth was 2.5 percent.)

With greater economic integration, the surplus labor pool could increase rather

than shrink. As part of its economic liberalization, Mexico has deregulated

agriculture and permitted sale of agricultural lands, withdrawn subsidies from

subsistence farmers, and opened Mexico's food and feed markets to greater

competition. Many Mexican peasants will be unable to compete with the United

States's highly mechanized grain exports once Mexican agricultural protection is

fully dismantled. Rural workers will flood industrial labor markets and depress

wages, offsetting any tendencies of labor markets to tighten from increased

investment.

It is also unlikely that heightened Mexican industrial productivity will lead

to higher wages. Mexican automobile engine plants, for example, operate at 80

percent of U.S. productivity rates, yet wages in these plants are only 6 percent

of U.S. wage rates. As Walter Russell Mead has documented, wages and

productivity diverge in export plants throughout the Third World. In Asia, as

nations like Bangladesh and Thailand have hosted increased transnational

investment, wages declined while productivity increased. In South Korea, it took

nationwide riots in 1987, toppling the Park-Chun dictatorship, before wages of

highly productive Korean workers began to inch up. In Mexico, real manufacturing

wages fell by 24 percent while industrial productivity increased by 28 percent

from 1980 to 1989.

In the United States in the 1980s, real wages also fell as industrial

productivity climbed, while in Japan and most European industrialized nations,

productivity and wages rose together. In the real world, the relationship

between productivity and wages is far looser than in textbooks; wages are

affected more by a government's fiscal, monetary, and labor market policies

(Mexico's "solidarity pacts," for example).


VIRTUAL UNREALITY

Experience plainly suggests that while Mexican productivity may grow, wages and

purchasing power may not rise, and U.S. exporters may not find the consumer

markets they've been promised in Mexico. Nonetheless, a widely cited claim for

U.S. export growth from NAFTA came in 1992 from Gary Hufbauer and Jeffrey Schott

of the free-trade-oriented Institute for International Economics, who predicted

that the treaty will create precisely 130,000 U.S. jobs.

Their claim, subsequently raised to 175,000, was picked up by economists (and,

of course, the Bush administration) noted for an utter inability to make

accurate predictions about other economic phenomena. The very forecasters who

can't predict future growth, unemployment, interest or inflation rates claim to

know precisely how many jobs the integration of Mexico and the United States

will create.

Free trade promotion has been supported by computer modeling, an academic fad

in which complex equations describing observed economic behaviors are fed into

computers and "run" with alternate policies. A variety of models

floated around Washington as NAFTA was being negotiated. The Hufbauer-Schott

version made several dubious assumptions--for example, that dollars invested in

Mexico would not otherwise have stayed in the U.S. but would have gone to Asia

or the Caribbean. Thus Hufbauer and Schott calculated the new jobs in Mexico

that would result from additional U.S. investment there, but declined to

calculate American job losses from a corresponding investment decline here.

Their assumption may have been valid in some cases (certainly Mexico's openness

has attracted some investment from Asia), but when they assumed it would be true

in all cases, they guaranteed that their computer analysis would predict exactly

the free trade benefits they hoped for. Garbage in, garbage out.

In 1987, the U.S. and Canada negotiated a free trade treaty. Similar computer

modeling helped win Canadian support. For example, two Ontario professors, David

Cox and Richard Harris, reasoned that Canadian companies would be more efficient

with unimpeded access to the larger U.S. market. By adding equations for these "economies

of scale," the professors computed that free trade would make Canada's GDP

grow by exactly 8.74 percent.

Other computers generated different estimates. A Canadian government commission

reported that benefits to Canada's economy would range from 3 percent to 8

percent, depending on the computer model used. Then-U.S. trade negotiator

Clayton Yeutter announced that Canadian duty-free exports to the U.S. would grow

to $19 billion annually, while U.S. exports to Canada would only be $13.5

billion.

The result was somewhat different. In the first two-and-a-half years of

Canada-U.S. free trade, Canada's economy actually shrank by 0.5 percent. Canada

lost 90,000 jobs and unemployment jumped from 7.8 percent to 10.5 percent. Cox

and Harris's computer predicted employment gains of 62 percent in Canada's

transportation equipment (auto) industry during this period; instead, employment

declined by 15 percent. Their prediction of 262 percent growth in Canada's

clothing industry became, instead, a 33 percent job loss.

These forecasting failures, along with economists' inability to predict other

trends, don't faze the modelers who now promote benefits of free trade with

Mexico. They have a ready explanation: Canada's job losses result not from free

trade but from the higher value of the Canadian dollar and the Canadian

recession. Had it not been for these, they aver, free trade would have produced

the predicted growth.

They may be right--or wrong. No economy behaves like these models. Currency

swings, business cycles, and changes in fiscal or labor policies will overwhelm

the isolated effects of a single policy like a trade pact with Mexico.

As imports from developing nations expanded in the

1980s, American manufacturing jobs were lost and real incomes declined. A

combination of policies contributed--not only low-wage imports but failure to

invest in education, public works, and worker training; a preference for

financial speculation over manufacturing; hostility to unions; budget deficits

requiring high interest rates and dollar values; and World Bank and IMF policies

to depress Third World purchasing power so that these nations' bank debts could

more easily be repaid.

Mexican wages have fallen in the last decade, despite employment and

productivity growth, because Mexico's need for export earnings to service a $100

billion foreign debt required ever lower wages to attract investors to export

plants. Mexican policy could not allow wages to increase, for rising incomes

would supply domestic purchasing power to compete with exporters for factory

production. If, on the other hand, Mexican incomes could have grown, Mexicans

would not only have purchased more U.S. goods but more products from their own

plants, leaving less available for export to the U.S. and thus less job

destruction here. All told, the U.S. suffered a decline of 1.1 million jobs as a

result of lost export sales from developing-nation debt crises of the 1980s.

With or without NAFTA, manufacturing jobs will continue to move south, while

Mexican incomes will remain too low to permit many purchases of American

consumer goods. We now have a temporary trade surplus with Mexico because of the

pent-up demand of Mexico's tiny middle class, because the peso's devaluation has

not proceeded rapidly enough to erase an artificially cheap dollar value (a

situation that cannot continue for long), and because we export so much

industrial machinery to Mexico. But the peso is not strong enough to support a

permanent trade deficit, and once our industrial machinery is in place in

Mexico, it will likely send a permanent stream of consumer products north,

creating a long-term trade deficit for the United States. Nor is there any

assurance that as Mexico industrializes it will keep purchasing capital and

intermediate goods disproportionately from the United States. The lesson of East

Asian development is that nations that establish strong export assembly sectors

can use their assembly plants as customer bases for new capital and intermediate

goods sectors.

Repudiating NAFTA would simply permit job losses to continue, along with

declines in living standards in both countries. So would simple ratification of

the treaty. The best opportunity to reverse the trend is to use NAFTA as a lever

to negotiate other agreements to reform the Mexican economy so its wages can

rise. Mexican incomes are presently too low, not only because debt service

obligations compete with consumption but because Mexico's income distribution is

so grossly inequitable.


MEXICO DIDN'T JUMP, IT WAS PUSHED

Conventional wisdom has it that Mexico, like much of Latin America, adopted its

current economic strategy--openness to foreign investment, wage repression, and

export orientation--after its previous experiment with import substitution

industrialization (ISI) failed. In response to this failure, Mexico is said to

have determined to copy the path to success paved by the Asian "tigers"--Korea,

Taiwan, Singapore, and Hong Kong--which experienced rapid growth by using export

earnings for purchase of capital goods, debt service, and then for consumer

imports to support a rising standard of living.

This conventional wisdom is wrong on two counts. First, Mexico's import

substitution strategy did not fail; in many respects it was highly successful.

And second, the development strategy followed by Mexico since 1982 bears not the

slightest resemblance to that of the Asian tigers.

Free trade proponent Rudiger Dornbusch acknowledges that "in the two

decades from the mid-1950s to the mid-1970s, Mexico was a model of financial

stability and economic development." Real annual growth in minimum wages

was 5.5 percent, and per capita income grew at an annual average rate of 3.6

percent. Indeed, even in the years leading up to the crisis, 1973-1981, when

Mexico's borrowing was excessive, the country's per capita income grew at an

average annual rate of 2.6 percent, despite rapid population growth.

Much of Mexico's current success as an American low-wage manufacturing center

is rooted in now-abandoned import substitution policies. A 1962 policy, for

example, prohibited sale in Mexico of autos that did not have Mexican-made

engines and transmissions. In 1969, the policy was modified to permit Mexican

firms to purchase foreign inputs, provided each firm maintained a positive trade

balance--earning the foreign exchange with its own exports.

In August 1981, a year before the beginning of the end of ISI strategies, the

Mexican government adopted a similar development plan for the computer industry.

Investors in the new computer industry were to receive preferential interest

rates and pricing of energy inputs, along with restrictions on competing

imports. In return, firms wanting to enter the computer industry would be

required to negotiate domestic content agreements with the government. This

development strategy has, of course, now been abandoned in keeping with Mexican

liberalization, but Mexico is now positioned to send low-wage auto and computer

exports to the United States.

Contrary to conventional wisdom, the import substitution strategies Mexico

followed prior to liberalization were rather like those of "successful"

Asian tigers. South Korea, for example, eschewed market policies that American

opinion now assumes Korea pioneered as a path to prosperity for Mexico.

For example, Mexico recently privatized state-owned banks. Yet when Korea's

industrial push began in 1961, dictator Park Chung Hee nationalized banks. As

Alice Amsden has shown, with control of credit, the government decided which

industries to promote, which firms could enter a market, which products they

could make, and in what quantity. Government-owned banks gave free credit to

protected industries. Such subsidies override market "discipline" and

are now anathema to officials in Washington and Mexico City.

Korea's industrialization limited "entrepreneurial risk" that

President Salinas now cites as his economy's salvation. Imports competing with

Korean goods were banned or subject to exorbitant tariffs. Korea required firms

to meet export targets while potential domestic competitors were denied

operating licenses.

Today Mexican planners nervously wait to see if free market reforms induce

wealthy Mexicans to bring their riches home. If there is any economic

explanation for Mexico's pursuit of NAFTA, it is the hope of giving Mexican

capitalists confidence that economic ties to the U.S. are irrevocable and that

therefore Mexico is a good place for Mexicans to invest. Despite 10 years of

economic "reform," more than $50 billion is still held abroad by

Mexicans seeking safer returns in places like Tokyo or New York. With some

Western interest rates (in Germany, for example) remaining at 10 percent or

higher, it is difficult to imagine why Mexican speculative capital would return

home if free market reforms were the sole inducement. Korea, on the other hand,

has had a different approach to "flight capital": unauthorized

transfer of Korean wealth abroad was punishable by death.

A central tenet of Mexico's free market strategy is movement toward an exchange

rate that reflects the peso's true purchasing power. Korea, in contrast,

manipulated its currency in violation of free market norms, combining currency

manipulation with capital controls, credit allocation, domestic content

requirements, and selective tariffs--all to promote industrialization and

export-led growth.

In 1968, Korea had a per capita income of $180, compared to Mexico's $580. By

1990, Mexico's per capita income was $2,490, while Korea's was $5,400. With

market reforms, Mexico's economy is growing at a 2 to 4 percent annual rate. But

Korea grew at a 9 percent rate in the 1970s; its new five-year plan is based on

7 percent real growth for 1992 to 1996.


WHY MEXICO CAVED IN

Why, then, did Mexico abandon its import substitution development model, which,

though imperfect, shepherded the nation through three decades of rapid growth?

The answer, of course, is that the nation's top economic strategists since 1982

have not been in Mexico City but in Washington. Mexico's strategy has been

dictated by the U.S. Treasury, the IMF, and the World Bank, which have imposed

on Mexico a version of trickle-down, supply-side Reaganomics more extreme than

that implemented or even contemplated at home.

Consider: In our recent presidential campaign, a common observation was that no

politician could expect election if, even in the face of unsustainable public

debt, he or she prescribed the kind of "pain" that Paul Tsongas,

Warren Rudman, or Ross Perot demanded--50 cents a gallon tax increases and

reduction of social security and Medicare benefits. Yet what was demanded of

Mexico? Real minimum wages in urban employment were cut by 47 percent from 1980

to 1989, and average manufacturing wages were slashed by 24 percent. Subsidies

to food producers were cut; consumer price subsidies for tortillas, beans,

cooking oil, bread, and eggs were reduced in the lowest income urban areas while

elsewhere these subsidies were entirely eliminated. Where government-run

businesses (parastatals) could not be sold to private investors, the

government closed them with minimal adjustment assistance for employees.

Government's withdrawal of services was so rapid that a fiscal deficit of 9.4

percent of GNP in 1982 became a surplus of 3.3 percent a year later.

By 1984, subsidies had declined by 43 percent from a year earlier. By 1985, the

cost of a basic food basket had risen to 50 percent of the minimum wage, up from

30 percent in 1982. The proportion of households below the "poverty line"

went from 37 percent in 1981 to 49 percent in 1989. The goal, however, was

achieved: Lowered wages helped Mexico's manufactured exports jump from $1.8

billion in 1982 to $3.3 billion in 1983. By 1989, manufactured exports were

worth $11.6 billion.

These policies could not have been implemented by a government that is "democratic"

in any meaningful sense of the word. Notwithstanding a ritual of Mexican "elections,"

it is only because Mexico is an unabashed autocracy that its leaders could

impose such pain without provoking widespread rebellion.

The lever Washington used to demand these sacrifices was debt. Mexico was

forced to abandon its preferred import substitution strategy because its debt

became unmanageable in 1982. There were three reasons for Mexico's virtual

default, two of which were beyond its control.

One was the Iran-Iraq war, in which both of those nations (encouraged by the

United States) attempted to finance their efforts by flooding world markets with

oil, pumped at rates in excess of OPEC quotas. The result was plummeting world

oil prices, going from $37 a barrel in 1981 to $8 by 1986. Mexico, not

unreasonably at the time, anticipated that prices would stay high, enabling the

nation to service its foreign debts as well as maintain an increasing level of

domestic investment. With the collapse of world oil prices, Mexico had little

alternative but to threaten its international creditors with default. A second

factor was the ill-conceived monetary policy adopted by the Federal Reserve's

Paul Volcker in 1979. Volcker's strategy was to break American domestic

inflation with exorbitant interest rates. Many Mexican loans were pegged to

prevailing rates.

The third cause of Mexico's economic crisis was that some of its foreign loans

had been inefficiently invested. This factor is heavily emphasized in

conventional accounts of the "failure" of import substitution

investment, which assert that foreign loans were siphoned off by corrupt

officials for either personal gain or private use. These accounts, however, are

radically overstated. Foreign capital may not always have been wisely

invested--for example, Mexico has not had to add new refinery capacity since

1982, suggesting that there was overinvestment in the petroleum industry before

the crisis. But corruption was an insignificant factor. In the absence of

exogenous shocks (plummeting oil prices and skyrocketing interest rates), even a

nation with Mexico's corruption could have continued to service its debt and

grow.

In 1982, Mexican finance minister Jesus Silva Herzog came to Washington

threatening default and begging for relief. Instead, he was told to slash living

standards and reduce wages--so that taxes could be used for bank payments, not

tortilla subsidies, and so that Mexico could attract privately financed export

industries to earn dollars for debt service. Mexico then signed an IMF "stabilization"

plan, in which banks lent Mexico funds equal to about half the interest due back

to the banks in the next two years, in return for Mexican commitments to

reorient the nation to free market policies. Still unable to service its debt

(though interest payments to foreign creditors rose from 66 percent of Mexico's

budget in 1982 to 79 percent by 1988), Mexico sought further relief. In 1985,

Treasury Secretary James Baker tried to persuade banks to lend Mexico (and other

Third World debtors) more funds for debt repayment. Banks refused; the Baker

plan flopped. In 1989, Baker's successor, Nicholas Brady, asked banks to soften

repayment terms (for example, by lowering interest rates or forgiving 35 percent

of the debt's value), but the Brady plan also won only slight relief. Meanwhile,

the IMF and World Bank (both heavily influenced by the U.S.) continued to

negotiate agreements with Mexico providing bridge loans and other temporary aid

to tide the country over, on condition that Mexico continue to follow free

market policies of depressed wages, reduced consumer subsidies, fewer social

services, less government participation in the economy, slashed tariffs

(Mexico's trade-weighted average tariff on U.S. imports is now only 11 percent)

and elimination of other "non-tariff barriers" to foreign penetration

of the Mexican economy. In 1986, Mexico joined the GATT, formalizing its

renunciation of import substitution development.

Yet despite these "reforms," Mexico's foreign debt (now approximately

$120 billion) is higher than it was ten years ago when the crisis began. As a

share (in constant dollars) of GDP, the debt is only slightly lower than it was

then. The Brady Plan, promoted as the solution to debt crisis, requires $58

billion of Mexican interest payments (and another $18 billion of amortization)

during the plan's first five years--1989 to 1994. Despite historically low

interest rates, Mexico devoted $9.5 billion in 1990 (28 percent of its export

earnings) to foreign interest payments, with another $3 billion going for

retirement of principal.

It was after the failure of the Herzog, Baker, and Brady negotiations that

President Salinas announced a willingness to sign a "free trade"

agreement to symbolize determination to attract U.S. investors to Mexico's

low-wage work force. As we have seen, however, whether NAFTA is ratified or

rejected will have little impact on the flow of investment from the United

States to Mexico. This flow is expanding but will never be sufficient to correct

Mexico's capital shortage. Because the structure of trade and investment

depresses living standards of working people in both nations, it is very much in

the U.S. interest to redefine our international economic policies as well as

negotiate anew with Mexico. Whether these negotiations are characterized as

separate from NAFTA, parallel to NAFTA, or a renegotiation of NAFTA itself is

immaterial and can be left to the convenience of presidential public relations

experts. Tactically, the best approach may be Bill Clinton's announcement that

he would hold up NAFTA's enabling legislation until new agreements are

negotiated. But the essential goal must be a joint development project that can

succeed in raising, not depressing, Mexican incomes. Rising Mexican incomes are

essential to creating a domestic market for Mexican industrialization,

developing reciprocal markets for U.S. exports, and relieving downward pressure

on American wages that stems from low-wage Mexican competition.


MUTUAL REFORM

A 2,000-mile common border does not permit us indifference to Mexican

development. Undocumented immigration, common pollution, and the danger of

political instability so close to Texas, New Mexico, Arizona, and California

require us to manage the relationship, not ignore it. Management has to focus on

increasing Mexican growth and incomes. NAFTA won't do it. What will?

In thinking about new negotiations with Mexico, we should keep in mind that

there is little meaning to distinctions we make between domestic and

international economic policies. As the failure of computer modeling

illustrates, it is nearly impossible to distinguish effects of mutually

reinforcing policies. For example, we need not worry about industrial relocation

to Mexico if our domestic policies aim for low unemployment, rising wages,

adequate adjustment and relocation assistance, high investment in leading-edge

industries, and regional development planning. Conversely, it helps little to

have programs that encourage investments in, say, technology centers in

Midwestern cities if the flight of manufacturing jobs to Mexico leaves in its

wake unemployment in the rural southeast or in immigrant communities in New

York, Miami, and Los Angeles.

Of course we need expanded job training and adjustment assistance for American

workers displaced by relocation of manufacturing to Mexico. Yet while this must

be part of a new North American strategy, more is needed, especially a

re-evaluation of American economic strategy towards developing nations in

general and Mexico in particular.

Debt relief and reform of IMF and World Bank development policies must be

cornerstones of a new economic relationship. The present downward spiral in

Mexico began with the debt crisis; it is foolish to try to end that spiral by

addressing every problem except the one that sparked Mexico's decline. If Mexico

could spend an additional $10 billion annually on American manufactures instead

of debt service, American jobs would be created while Mexico gained both

industrial machinery and consumer products--a "win-win" transaction.

Every billion dollars earned by Mexico's exports, if then spent on purchases of

American consumer and capital goods, would create about 30,000 U.S. jobs. If

Mexico's earnings are transferred instead to international bankers, many of

those jobs are lost.

There's no principle at risk in forgiving Mexican debt obligations. The Bush

administration repaid Egypt for its support of Desert Storm by organizing

Western European creditors to forgive $20 billion of Egyptian debt. To encourage

Eastern European reformers, we arranged to wipe out $17 billion of Poland's

foreign debt. At various times in the last two years, we have pressed allies to

let Russia suspend payment on its $65 billion foreign debt -- hoping it could

use the cash instead to buy Kansas wheat. The U.S. blows hot and cold on the

issue of Russian debt relief, but the issue is never whether debt relief is an

improper reward for Soviet profligacy; rather, the issue is solely whether

policymakers believe controls are in place to assure that relief will be

properly expended (on import of American products and ideology).

Our domestic bankruptcy law permits troubled firms to use revenue for operating

expenses rather than onerous debt repayment. Firms whose problems are far less

serious than Mexico's use these procedures. Mexico slashed wage rates in half to

maintain regular interest payments in the 1980s, but no U.S. bankruptcy judge

would require so drastic a wage cut before permitting a firm to ignore

creditors. Even complete debt forgiveness would be relatively inexpensive,

costing the U.S. much less than the over $100 billion that Mexico now owes. U.S.

banks now sell Mexican debt for about 45 cents on the dollar -- guaranteed "Brady

bonds" sell for 60 cents. Even if Western nations compensated banks fully

(at market rates) for Mexican debt forgiveness, it would cost a total of only

about $40 billion (comparable to Western expenses for Polish and Egyptian

concessions).

While budget constraints limit our willingness to purchase Mexican debt, the

burden could be offset by requiring Mexico (dollar for dollar) to buy American

machinery and intermediate goods with funds otherwise designated for debt

service. This requirement has historically been attached to foreign aid funds,

beginning with the Marshall Plan for Western Europe; it is today precluded not

by logic but by ideology. Such a proviso could provide stimulus to underutilized

American capacity, resulting in increased income tax revenues and reduced

transfer payments (welfare and unemployment), offsetting, to some degree, the

budgetary cost.

With the election of Bill Clinton as president, John Major's Great Britain

becomes the only remaining industrialized nation that pretends to subscribe to

the fanciful economic nostrums we blithely impose on the developing world. And

it will be recalled that in September 1992, when Britain was faced with the

orthodoxy of repressing its economy to service its debts, it instead dropped out

of the European exchange-rate mechanism, a luxury not permitted Mexico (whose

debts are denominated in dollars).

Redefinition of IMF and World Bank policies are required so that these

institutions, in negotiations with Mexico and other developing nations, cease

demanding adoption of laissez-faire policies more extreme than any

industrialized nation (including the U.S.) would dare contemplate. Once

ideologically motivated officials came to dominate the IMF and World Bank during

the Reagan-Bush years, these international institutions have demanded that

developing nations adhere to an orthodoxy much more extreme than the

institutions' official policies.

The IMF and World Bank need a new development model and practice, adapted from

the successful experiences of nations like Korea, Japan, Germany, and the United

States, not from textbook laissez-faire theories. Whether in negotiations with

the United States or its surrogates, the IMF and World Bank, Mexico should be

encouraged to return to some policies that worked in its import substitution

period, while avoiding the period's excesses. The nation should be permitted and

encouraged to specialize not just in those industries that pay wages too low to

remain in the United States.

With an industrial strategy that complements our own, some Mexican industries

could be protected or even subsidized. The Korean model is appropriate to avoid

inefficiencies that resulted from excessive protectionism of the ISI model; a

few designated industries could be expected to earn the protection of their

domestic markets by becoming sufficiently competitive to compete

internationally.

A continental development strategy should include

development assistance from the United States to Mexico. While this aid will be

limited by American budgetary pressures, a commitment to common North American

development requires a reorientation of American foreign development assistance

priorities.

Nowhere in the world has free trade been attempted between economies at such

disparate levels of development. When West Germany incorporated East Germany in

an economic union two years ago, the German government made direct transfers of

wealth to each East German citizen, along with an artificially low exchange rate

for East German marks--to avoid uncontrolled immigration of workers from East to

West and uncontrolled migration of production from West to East.

The European Community, when incorporating Spain, Portugal, and Greece,

recognized that if economic integration were not to pull its prosperous members

down to the level of its poorer members, development aid had to be granted from

EC coffers to less developed regions. The European Community treaty commits its

member nations to "reducing disparities between the various regions and

backwardness of the least favored regions." The European Investment Bank

and Regional Development Fund support infrastructure projects in the poorer

member nations, building roads, upgrading communications, underwriting

industrial development. Consequently, wages in the poorer nations have climbed,

and wage-driven relocation of manufacturing from northern to southern European

nations has been minimal.

In contrast, total official development assistance to Mexico in 1990, from all

industrial nations and international agencies, totaled only $140 million, less

than one-tenth of one percent of Mexico's GNP--or an average of $1.60 per

Mexican citizen.

Mexico reasonably claims that its abysmal environmental record results mainly

from lack of resources. In 1980 and 1981, Mexico used 80 percent of its

government budget for programs other than interest payments. From 1983 to 1988,

the average was 50 percent. Mexico cannot be expected to increase its

environmental enforcement budget and infrastructure investments at the same time

that the U.S. Treasury, the IMF, and the World Bank are enforcing debt repayment

schemes that require Mexico to deregulate its economy, reduce its public sector,

and devote whatever resources are available to debt service.


HOW MEXICO CAN HELP ITSELF

On the other hand, the burden does not belong entirely with the United States

and its development agencies. Mexico should be expected to do more on its own

behalf, and international assistance cannot be the only source of funds for

development.

Tax Reform. Domestic investment funds can be raised in Mexico itself by

tax reform--by an increase in taxation, by improving the efficiency of tax

collection, and by correcting the excessive regressivity of the Mexican tax

system.

Of the nations that the World Bank classifies as "upper middle income,"

Mexico's tax collections are among the lowest. It collects 14 percent of its GNP

in taxes, compared, for example, with Portugal, which collects 35 percent;

Venezuela, 17 percent; Uruguay, 27 percent. Mexico has no capital gains tax

(except on real estate), not even on speculative profits made on the Mexico City

stock exchange in the last three years. Less than 20 percent of Mexico's

businesses are registered with the tax collection authorities. Prior to the

privatizations of the last decade, most government revenue came not from taxes

but from the earnings of parastatal enterprises. Now this source of revenue has

disappeared as even profitable state-owned businesses like banks, airlines, and

utilities have been sold. Pemex, the petroleum monopoly that remains

state-owned, contributed fully one-third of the government's revenue in 1991,

yet free-market theorists recommend that Pemex be privatized as well.

Mexican political economist Jorge Castaneda lists six elements of tax reform

needed if welfare and public investment goals are to be established: corporate

taxes must be increased; taxes on wealth levied; capital gains taxes on

financial markets established; collection improved; income taxes enforced on

independent professionals and the upper-middle class; and taxation of assets

held abroad.

The latter, which would go far toward bringing flight capital home, requires

negotiation of effective tax treaties with the United States and other

finance-center nations like Britain, Japan, and Germany. Such cooperation is

essential for continental development and costs the industrialized nations very

little. While Mexican flight capital is of enormous consequence to Mexico,

Western nations could easily forego the additional capital they obtain as tax

havens for wealthy Latin Americans.

Health and Education Reinvestment. To become a profitable market for

U.S. exports, as well as a successful exporter of higher value-added goods,

Mexico must be permitted and encouraged by U.S. and international development

agencies to reinvest in the education and health of its youth. Mexico's

productivity is doomed to lag, offsetting much of the value of increased foreign

investment, because the structural adjustment policies the U.S. imposed on the

nation required a reduction in spending for education, health, and nutrition.

Education spending declined by a third, from 3.8 percent of GDP in 1982 to 2.8

percent in 1983, and it has remained at this lower level. Health spending went

from 3.7 to 3.0 percent in the same year, and has also stayed down since.

Mexican children who were preschoolers when the economic crisis began in 1982

will be entering the work force within the next five years. They are less

nourished and less educated than the previous generation of Mexican workers and

so will be less productive. (They will also, incidentally, perform more poorly

as immigrants in American schools.)

Minimum Wage Increase. American and international agency negotiators

should include in their continental development strategy a gradual increase in

the Mexican minimum wage, currently about $.60 an hour. Remember again that this

minimum is half its 1982 level and was reduced by Mexican policy at the behest

of international creditors, in a bold transfer of wealth from American exporters

(and their work forces) to creditor nation bankers.

But policies to make Mexican exports cheap in America also make American

exports too expensive in Mexico. American exports to Mexico declined

dramatically during the "structural adjustment" of the 1980s. Mexico's

annual imports of goods and services dropped from $21 billion to $8 billion from

1982 to 1983. These failed policies to cheapen Mexican export wages should be

reversed. The ultimate goal should be a common U.S.-Mexican minimum wage, at the

U.S. level. There are several benchmarks by which intermediate goals could be

established. A comparison of the wage share of GDP in the U.S. (55 percent) and

in Mexico (15 percent) suggests that Mexican wages could triple. If the standard

is workers' earnings as a percentage of manufacturing value-added (20 percent in

Mexico, 35 percent in the U.S.), an immediate wage increase of 75 percent would

be in order. Labor productivity in export industries (roughly equal to U.S.

rates) suggests that an even greater increase could be appropriate.

Regardless of what standard is adopted, the rate of increase in the Mexican

wage should be rapid enough to provide Mexican workers with significantly

increased purchasing power, appropriate to their productivity levels, yet slow

enough to continue to entice new investment. Immediate increases could be

considerable. Asian nations attract U.S. runaway shops with wage rates much

higher than the Mexican standard.

There is precedent for careful incorporation of low-wage areas into the

American market. In Puerto Rico, for example, industry wage boards established

minimum wages for specific industries. Nonetheless, most minima were reasonably

close to the mainland standard. In 1960, the mainland minimum wage was $1 an

hour; of 98 different industry minima on the island, 73 were $.70 or higher and

only 6 were less than $.50. Gradually, the differential was reduced, until in

1981 parity with the mainland was reached at the $3.35 level. The differential

was maintained so that labor-intensive firms would have incentives to invest in

Puerto Rico. But the differential was small enough that it did not create a

hemorrhage of U.S. firms relocating solely to take advantage of low wages. The

strategy worked. From 1960 to 1989, Puerto Rico's real per capita personal

income has grown steadily, at an average annual rate of 3.7 percent. Since

island industries have been required to pay the full mainland minimum wage in

1981, per capita growth has averaged 3.3 percent. During this same period of

Mexican crisis and liberalization, Mexican per capita income growth has declined

by an average rate of over one percent a year.

Environmental Standards and Privileged Market Access. A continental

development strategy should also include harmonized environmental standards and

enforcement procedures. While Mexico's environmental regulations are already

close to those of the United States, enforcement has often been nonexistent. The

Bush administration, in answering environmental critics, insisted that NAFTA

would itself lead to a clean environment by generating wealth that could be

dedicated to a national clean-up. But Bush also promised to develop a

bi-national environmental plan parallel to but not part of NAFTA. It was an

empty promise. The bi-national plan committed U.S. contributions of only $380

million and Mexican contributions of $340 million over the next three years.

Responsible estimates of the costs of cleaning up pollution already created by

reckless relocation of U.S. manufacturing along the Mexican border range from

$18 billion to $50 billion.

The obvious flaw in an approach that aims at upward harmonization of Mexican

and U.S. labor and environmental standards is that Mexico competes with other

Asian and Latin American developing economies for U.S. investment, based on

offers of the lowest labor and regulatory costs. If a Mexican development

strategy expects wages and regulatory costs to increase, a likely result would

be the flight of international capital to other Third World nations that are not

under similar requirements to raise labor and regulatory costs.

The Bush administration's goal was to negotiate worldwide "free trade"

with lower wage nations. After NAFTA was ratified, free trade agreements with

Chile and Eastern Europe would follow. All the while, the administration pursued

an "Enterprise for the Americas" with Latin America that, building on

NAFTA and the Caribbean Basin Initiative, offered unrestricted access to U.S.

markets in return for Latin nations' agreements to privatize economies, reduce

the size of government, and adopt low-wage export platform strategies.

As we have seen in the apparel industry, however, if all developing nations are

given privileged access to the U.S. market, none can have it. Clearly, the U.S.

cannot be the market of (first and) last resort for every developing economy. A

continental development strategy with Mexico can work only if the goal of

worldwide free trade is abandoned, and Mexico, perhaps along with the Caribbean

Basin nations, is given privileged access to the U.S. market. There are, as

suggested earlier, good security reasons for singling out Mexico and the

Caribbean in this fashion. Not only need we be more concerned with political

instability here than we are with instability elsewhere, but there is ultimately

no way of slowing the rate of undocumented migration from Mexico and the

Caribbean save with a meaningful development strategy for the sending areas.

This was also, of course, one of the rationales for NAFTA, but free trade, with

its prospects for furthering the depression of Mexico's urban living standards

and disrupting traditional peasant economies in rural areas, will be more likely

to stimulate immigration from Mexico than to staunch it.

Neither wage nor environmental harmonization can work unless the North American

market is protected from undermining by other nations. Raising Mexico's minimum

wage to U.S. levels will do little good if transnational investors can then

relocate Mexican plants to the Philippines or Sri Lanka. To prevent such

runaways, we need new tariff walls to protect the developing prosperity of North

America.

Our free trade area should accept only those third country imports manufactured

with wage and environmental standards comparable to those required here.

Practically speaking, the protection of harmonization could be accomplished by

levy of a "social tariff," taxing third nation imports an amount equal

to the difference between the wage paid and that which would be required if an

acceptable minimum was enforced, calculated on a similar basis to the new

minimum in Mexico. A similar tariff could be levied to represent the costs of

environmental responsibility.

Critics may reject U.S. requirements for increased investment in health,

education, labor, wage, and environmental standards as an affront to Mexico's

sovereignty. But Mexico's present policies of disinvestment in these areas are

all consequences of earlier demands by the U.S. and its development agencies.

Objection to new policies out of "respect for neutrality" in Mexican

domestic policy is a smokescreen. The present NAFTA draft contains numerous

Mexican accommodations to demands for changes in domestic policy--Mexico's legal

(commercial dispute resolution) system, its intellectual property laws, and its

investment rules. Reforms of Mexico's domestic fiscal, welfare, and labor market

policies are now more sorely needed.


AN ALLIACE FOR PROGRESS

If the United States negotiates anew with Mexico, we could well succeed in

raising Mexico's living standards and ability to purchase U.S. exports.

President Salinas, we can assume, is not opposed to higher wages in principle;

incomes have been slashed because of bankers' demands, not because a low-wage

development strategy was freely chosen. If a new American administration can

abolish supply-side economics at home, it could well find a friend in Mexico's

leader, now freed from external demands that reactionary remedies be imposed as

the policy of his nation as well.

While NAFTA opponents miss the mark with exaggerated predictions that the

treaty will accelerate U.S. investment in Mexico (which already proceeds at

breakneck speed), they correctly assert that by codifying laissez faire in a

treaty, NAFTA would make i

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