NAFTA: Setting the Record Straight

Nora Claudia Lustig

On July 1, President Clinton must submit a report to the U.S. Congress on the first three years of NAFTA. During the past three years, NAFTA has resulted in an increase in U.S.-Mexican trade, business partnerships, specialization in production processes, and direct investment flows into Mexico. At the same time, the agreement has protected U.S. exporters from the brunt of the Mexican crisis, especially in comparison to exporters from Japan and the European Union. Though it is true that U.S. exports to Mexico shrank during 1995, this fall was not generated by NAFTA but by the Mexican devaluation and the subsequent financial crisis. Furthermore, contrary to some belief, NAFTA was not a cause of the Mexican crisis and is now one of the pillars of Mexico’s economic recovery. Finally, there is evidence that NAFTA has created more jobs than it destroyed.

Yet there is an unfinished agenda. Member countries should avoid violating the principles or the letter of the agreement. An example of such violation is the unilateral decision by the United States to overrule allowing the passage of Mexican trucks into U.S. territory as stipulated in NAFTA. On labor issues, the U.S. National Administration Office should be more forceful in its recommendations on the cases of violations of Mexican workers’ freedom of association. Furthermore, despite its large stock of capital, the North American Development Bank (NADBANK) has only issued a handful of loans. To a large extent, this is because many environmental projects do not qualify for loans established on strictly commercial terms. An effort to clean up and protect the environment, especially at the U.S.-Mexican border, will require some subsidization in the form of nonrefundable grants to cofinance environmental projects with high social returns.

To turn NAFTA into a genuine building block for global free trade, the three member countries should continue reducing their tariff structure for Most Favored Nation status and move toward a common external tariff. They should also accept the incorporation of willing new members (such as Chile) into NAFTA.


Has NAFTA failed? The short answer is no. Though it will take many more years before a meaningful assessment of the agreement can be made, NAFTA’s expected benefits are beginning to materialize. Trade among the three NAFTA countries has been expanding to record levels, and the number of U.S.-Mexican business partnerships is on the rise. Moreover, despite the 45 percent real devaluation of the peso, the 7 percent drop in Mexican output, and Mexico’s 22 percent fall in real wages during 1995, U.S. exports to Mexico were much less affected than Japanese or European exports, largely due to NAFTA. Indeed, while exports to Mexico from the rest of the world (notably Japan and the European Union) fell by about 25 percent, U.S. exports contracted by less than 2 percent.

Despite these positive trends, many Americans within Congress and outside it are proclaiming that NAFTA was a mistake. To a large extent, the statements against NAFTA are based on erroneous beliefs or egregious distortions. NAFTA is blamed for U.S. job losses or declining living standards of workers, particularly among unskilled persons. In reality, the impact of NAFTA on gross job displacement in the United States has been negligible. Furthermore, there is some evidence that the net employment effect (the difference between jobs displaced and jobs created) has been positive.

Another argument used against NAFTA is the fact that following the Mexican peso crisis the United States is running a trade deficit with Mexico. However, unless it is the result of restrictions in market access, a deficit with any one country is by no means a cause of distress in the country running the deficit. NAFTA’s success must be measured by the total amount of trade it creates, regardless of which country is in deficit.

Finally, though some of NAFTA’s critics argue that the agreement was a cause of the Mexican peso crisis, in reality the crisis was caused by factors unrelated to NAFTA. In fact, NAFTA is an important contributing factor to Mexico’s economic recovery because of its impact on export performance and foreign direct investment flows.

These misperceptions probably reflect a deep-seated frustration with rising income disparities and declining real earnings of less-skilled workers in the United States, for which trade with developing countries is frequently blamed. So far, the sentiment prevailing in Congress regarding NAFTA and its extension has been strong enough to inhibit the Clinton administration from requesting congressional approval for fast-track authority to negotiate the accession of other countries to NAFTA or any other free trade agreement. If current trends continue, it is unlikely that the United States will be able to remain a credible player—let alone a leader—in the quest for hemispheric free trade.

To construct long-lasting support in the United States for NAFTA (and for free trade more generally), action is needed on three fronts. First, the administration must undertake a systematic public education effort, both with Congress and the general public, about NAFTA and its actual effects. Then, further steps are required to make good on the promises imbedded in so-called labor and environmental side agreements. NAFTA critics are right in one respect: There is no reason to forego NAFTA’s contribution to the protection of workers’ rights (particularly in Mexico) or improved environmental conditions, especially along the U.S.-Mexican border. Finally, identifying ways to address the rising economic polarization and declining living standards for less-skilled workers in the United States deserves greater attention on the part of policymakers. Otherwise, many lawmakers are likely to continue focusing on the wrong instrument—that is, trade protection—to combat it.

Nafta and Mexico’s Economic Performance

Was NAFTA a cause of Mexico’s 1995 financial crisis? Some observers have argued that it was. However, Mexico’s large, rising trade deficit was not the result of the reduction in trade barriers implied by NAFTA but was caused by an appreciated value of the peso; that is, the dollar was allowed to become too cheap. Furthermore, though the trade deficit contributed to peso’s devaluation, there were other events that were equally important (or even more so) in explaining Mexico’s financial debacle of 1995.

The Mexican financial crisis was the result of a combination of rising U.S. interest rates, political shocks, and market hysteria on the one hand, and erroneous policy responses from Mexican authorities on the other hand. Three events in particular—the Zapatista guerrilla uprising in Chiapas, the assassination of the PRI presidential candidate, and the assassination of the PRI secretary general—generated a climate of uncertainty among investors during 1994. In the aftermath of the assassination of Partido Revolucionario Institucional (PRI) presidential candidate Luís Donaldo Colosio in March 1994, Mexico lost close to $10 billion, or about 40 percent, of its international reserves.

Though NAFTA cannot be blamed for the peso crisis, it is surely contributing to Mexico’s recovery. Economic growth in Mexico brings good things to the United States in the form of increased exports and reduced migration. The Mexican economic recovery got under way in the third quarter of 1995, and the 7 percent decline in GDP that year was followed by a 5.1 percent growth in output during 1996. Exports have been the engine of Mexico’s recovery. Overall, they grew by 30.5 percent in 1995, with nonoil exports rising by 36.3 percent. One indicator of NAFTA’s role in this process is that the average rate of growth of Mexican exports to the United States was more than ten percentage points higher after 1994 than in 1991—93. The sectors showing the highest rates of growth were those where the regional integration was fairly advanced even before NAFTA: autos and auto parts, as well as textiles and apparels, food and beverages, and agriculture and cattle products.

NAFTA’s impact is also observable in the behavior of foreign direct investment, another important contributing factor in Mexico’s economic recovery and future growth prospects. On average, between 1994 and 1996 foreign direct investment is almost double (close to $8 billion a year) what it was in the three years before NAFTA’s implementation. Moreover, in 1995, when portfolio flows became highly negative, foreign direct investment was 75 percent above the level in the three years before NAFTA. A comparison with the previous crisis may be telling. During 1983, foreign direct investment fell to one-fifth of what it had been in the previous years. Clearly, the business opportunities brought by NAFTA have had a positive impact on foreign direct investment decisions, the peso crisis notwithstanding.

Unfortunately, the economic recovery has not yet reached the pockets of the average Mexican: Between 1995 and 1996, real manufacturing wages fell cumulatively by more than 25 percent. But if current economic trends continue—and current forecasts suggest they will—real wages should start growing (albeit slowly) once more. Still, it could take several years for Mexican wages to reach their precrisis levels. But without NAFTA, it would have taken much longer.

Nafta and U.S. Trade

The relative size of the U.S. economy versus Mexico’s—about 25 to 1—will always limit the effects of NAFTA to very small orders of magnitude. Imports from Mexico as a share of total annual U.S. imports, for example, have averaged about 6 percent. Investment in Mexico is a tiny percentage of overall U.S. investment. For example, in 1994, direct U.S. investment in Mexico was $3 billion, or about 0.3 percent of U.S. gross private domestic investment of more than $1 trillion.

Furthermore, assessing NAFTA’s impact could prove futile. The sharp devaluation of the Mexican peso and the crisis that followed clearly overshadow the effects of NAFTA’s implementation. The devaluation and the recession caused a sharp decline in U.S. exports to Mexico, and Mexico’s $2.4 billion trade deficit with the United States in 1993 became a surplus of $15.4 billion in 1995. In addition, NAFTA is just one part of a continuing process of economic integration between Mexico and the United States, a process that accelerated with Mexico’s trade liberalization introduced in the mid-1980s. The benefits and the costs of economic integration will be spread out over many years. Even in the longer run, the size of the U.S. economy relative to Mexico will always limit the effects of trade and investment flows with that country.

Nevertheless, there are indications that NAFTA is making its imprint on both the magnitude and composition of bilateral trade flows. For example, during 1994 (NAFTA’s first year), trade between the NAFTA partners grew 17 percent during 1993, reaching a record $350 billion, of which about $100 billion represents U.S.-Mexico trade.

Taking a longer perspective, all of U.S.-Mexico trade surged from $30 billion in 1986 (a year after Mexico began its trade liberalization) to an estimated $140 billion in 1996.

In 1995, NAFTA worked to preserve and promote trade, despite Mexico’s economic crisis. In contrast with the crisis in 1982, when Mexico reintroduced import permits for most products, this time it kept its open-economy policies largely in place. Tariffs were increased to their GATT-bound levels in only a handful of economic sectors. But because of NAFTA, the United States—as well as other countries that had signed free trade accords with Mexico—was spared this tariff increase. Moreover, in 1995, while exports from the United States fell by only 2 percent, exports from non-NAFTA countries (notably, Japan and the European Union) fell by 25 percent. Part of the difference in export performance between the United States and other exporters to Mexico might be attributed to the depreciation of the dollar vis-à-vis other major currencies in 1995. However, most must be ascribed to the expanded market access for U.S. exporters and the growing importance of intraindustry bilateral trade, both strengthened by NAFTA. NAFTA appears to have shielded U.S. trade from the brunt of the Mexican crisis and the increase in some tariff lines that followed.

U.S. Employment and Wages

Before NAFTA’s approval, all opponents claimed the agreement would lead to significant job losses in the United States. Cheap, labor-intensive Mexican imports would outcompete with U.S. goods, and plants would be attracted to Mexico by lower wages.

Three years of evidence reveals that such fears were unfounded. One indicator of the gross disemployment effects caused by NAFTA is the Trade Adjustment Assistance (NAFTA-TAA) certifications for all industries given by the Department of Labor. The cumulative figure between January 1994 and December 1996 equals close to 90,000 certifications. Sixty percent of these are Mexico-related (as opposed to Canada or unspecified country). Forty percent of this amount is due to plant relocation, and the rest to employment displaced by imports. However, this number is the total number of recipients of NAFTA-related assistance, which is not equivalent to the total number of people who may be unemployed as a result of NAFTA. USTR figures indicate that about 6,000 of eligible recipients actually used the benefits, suggesting that the rest have probably been reemployed. Also, an accurate assessment of the net employment effect of NAFTA would need to look at job creation as well. A recent study that attempts to do this analytically found that the overall impact of NAFTA tariff liberalization on U.S. employment has been slightly positive.

Job displacement may be causing real hardship for some individuals and families, but it is important to put these figures in context. Since NAFTA, the United States has created about 2.25 million jobs a year. Furthermore, according to the Bureau of Labor Statistics, total gross job displacements (subsequently reemployed in most cases) during the first nine months of 1996 averaged 2.4 million workers per month. On a monthly basis, the NAFTA-TAA certified workers since the agreement came into effect equal 2,569 a month (82,223 divided by 32 months). NAFTA-certified job displacements were only about one in 1,000 of the average monthly layoffs during the first nine months of 1996.

Given U.S. wage flexibility, a more relevant measure of NAFTA-related hardship for American workers may be its effect on wages, particularly for less-skilled workers. Though NAFTA’s effect on wages has not been estimated, the impact of trade on U.S. wages has been studied extensively. The majority of these studies conclude that international trade explains a small share of the observed rising wage inequality and downward trend in real wages of less-skilled U.S. workers. In general, it is technological change—with its bias in favor of high-skilled labor—that is the main factor behind these trends. It may be worth noting that even if trade protection may bring small, short-term relief for unskilled workers, this will be at the expense of lower growth and living standards (including those of less-skilled workers) in the future. A more fruitful alternative would be to pursue policies designed to upgrade the education and skills of the working population.

Labor and Environment

To respond to U.S. congressional interest in incorporating labor and environmental issues into the negotiations, the Clinton administration negotiated the North American Agreement on Labor Cooperation and the North American Agreement on Environmental Cooperation, known as NAFTA side agreements. Mexico and the United States alone established the Border Environment Cooperation Commission (BECC) and the North American Development Bank (NADBANK). The BECC “is expected to assist border states in both countries to design and finance environmental infrastructure projects in the border region. NADBANK is expected to provide financing for environmental projects certified by BECC and also to provide support for community adjustment and investment projects.” As part of the so-called labor side agreement, a federal government level office in each country called the National Administrative Office (NAO) was created. One of its functions is to receive public complaints about nonenforcement of the own-country labor law.

The labor and environment NAFTA side agreements were introduced to gain votes in the U.S. Congress at the time of NAFTA’s approval. However, organized labor, many Democrats in Congress and some environmentalists were not satisfied with the agreements because, in their words, they lack teeth. That is, no real provisions were made to use trade sanctions against violators of the side accords.

The lack of provisions to use trade sanctions within the agreements is a blessing. Otherwise, environmental and labor issues could have been frequently used as excuses to introduce protectionist barriers and thereby obstruct NAFTA’s implementation. Not even the European Union, so keen in harmonizing social standards, uses trade sanctions in the face of labor or environmental law violations. In the European Union, complaints are brought before the judicial system by the interested parties in the country where the violation took place. The rulings must be consistent with European Union norms, but all the remedial action is undertaken within the country so that the party that has been damaged receives appropriate compensation.

Still more could and should be done, both on the labor and environmental fronts, by the governments and NAFTA-created institutions. One repeated concern expressed by U.S. labor leaders is that, given the characteristics of Mexico’s political system and the corporatist role played by the official unions, Mexican workers still find it hard to form and belong to independent unions. This concern is well founded even in today’s more democratic Mexico, where independent unions may face serious obstacles to be recognized. This appears to have been the case in several of the complaints brought before the U.S. National Administrative Office. But the recommendations of NAO indicate an overcautious approach in dealing with this kind of labor rights violation. Even if NAO’s formal recommendations on these matters are not the equivalent of rulings and do not lead to sanctions under the current terms of the side agreement (such as fines imposed on the country where the violations occurred), greater exposure of such violations could eventually lead to a reduction in them. This would require a stronger stance on the part of the national NAO whenever such complaints are brought to its attention, even if they pertain to another of the NAFTA members.

On the environmental front, the North American Development Bank (NADBANK) could be made an effective tool to foster environmental protection and cleanup, especially along the U.S.-Mexican border. The Bank’s capital will soon increase from $1.5 billion to $2.25 billion. However, since its establishment, the Bank has approved only three loans totaling a mere $2.98 million and issuing guarantees for $1 million. One factor behind this low level of activity is that the established procedure, in which projects are certified by the BECC before they are analyzed for their financial viability by NADBANK, may be flawed. Switching the order in which projects are analyzed and approved may expedite loans.

Another fundamental reason for this low level of lending is that the Bank’s charter constrains it to operate on strictly commercial terms. Many of the potential borrowers (local governments, nongovernmental organizations [NGOs], etc.), particularly in Mexico, lack the administrative experience and the ability to borrow funds or are simply ineligible because they would never be able to repay the loans required to finance a specific project. Environmental projects will need some form of subsidization. If NADBANK cannot lend at below-market rates, other sources, such as governmental nonrefundable grants or private donations, will be needed to cofinance the projects with high social returns. Although this is already happening, the scale has been too small. As every other development bank, NADBANK may eventually need a window of credit on concessional terms for the poorest and most vulnerable communities. Furthermore, the bank should probably expand its portfolio of eligible projects to include housing, education, and poverty reduction projects more generally. This would not be in violation of its charter, and such projects could have important environmental effects.

Final Observations

During the past three years, NAFTA has produced an increase in U.S.-Mexican trade, business partnerships, specialization in production processes, and direct investment flows into Mexico. At the same time, it has protected U.S. exporters from the brunt of the Mexican financial crisis, especially in comparison to exporters from Japan and the European Union. Though it is true that U.S. exports to Mexico shrank during 1995, this drop was not generated by NAFTA but by the Mexican peso’s devaluation and the subsequent financial crisis. Furthermore, contrary to some beliefs, NAFTA was not a cause of the Mexican crisis and is now one of the pillars of the country’s economic recovery. Finally, loss in American employment caused by NAFTA has been tiny despite a significant increase in the U.S.-Mexican wage gap caused by the peso crisis. There is even some evidence that NAFTA has created more jobs than it has destroyed.

But progress is still needed in a number of areas. The United States and Mexico must contribute to the fulfillment and consolidation of NAFTA’s original objectives. Several recent incidents underscore the need to deter the influence of powerful lobbies that may conspire against NAFTA’s full implementation. An example of the latter in the United States is the decision to unilaterally overrule allowing the passage of Mexican trucks—in effect a violation of NAFTA. One way to avoid such situations would be to replace national trade remedy laws with an international competition code. This could shield the trade disputes from political pressures of powerful vested interests. Since the U.S. political climate is not ripe for giving up national trade remedy laws for internationally set codes, the responsibility to make good on NAFTA’s commitments rests primarily with the U.S. executive branch.

Additional efforts are necessary to make the institutions contemplated in the labor and environment NAFTA side agreements more effective. In particular, the U.S. National Administrative Office should be more forceful in recommending action on the part of the Mexican government in cases where Mexican workers’ freedom of association is violated. In a country where the head of the Mexican equivalent of the AFL-CIO publicly threatens to retaliate against those who will not vote for the official party, external pressure can play a significant role in improving the protection of workers’ rights guaranteed under Mexican law but not always enforced. The federal, state, and local governments on both sides of the border should also step up their contribution to make more projects eligible for loans from the North American Development Bank. This will require making available nonrefundable grants to cofinance projects with a high social return. Given Mexico’s proximity, helping Mexican communities to improve their living and environmental conditions can have large payoffs for the United States.

In December 1994, at the Miami Summit of the Americas, the United States vowed to pursue the economic integration of the hemisphere and form a free trade area by 2005. Since then, little progress has been made. It is true that the hemispheric working groups created after the Summit are doing the groundwork to achieve that objective. But the Clinton administration has been slow in requesting fast-track negotiating authority in Congress to begin formal negotiations. Chile, for example, has repeatedly manifested its interest in becoming a member of NAFTA and has completed free trade agreements with Mexico and Canada. However, its accession to NAFTA has become enmeshed in U.S. domestic politics.

A laggard United States will not devastate the future of economic integration in this hemisphere. However, because of its size, the U.S. market is the biggest economic prize. Without that prize, the incentives to sustain open economic policies in certain countries will diminish. The U.S. could also lose opportunities for expanded investment and trade. For example, as the largest market in Latin America, Brazil could be a significant lost opportunity for the United States should the process of liberalizing trade and nontrade barriers between the two countries not take place. Furthermore, Central America and the Caribbean governments claim that being excluded from NAFTA has already had negative effects on their economies. The prosperity and stability of these countries are also of vital interest to the United States, because they are sources of migratory flows and a conduit for drug trafficking.

Now that the rest of the region is ready to move forward with economic integration, it is ironic that the United States, after decades of promoting the principle of free trade, appears hesitant. This image can only be removed if the Clinton administration moves forward with a request for fast-track negotiating authority and—together with its two partners—soon negotiates with Chile its accession into NAFTA. Going with free trade could well be like learning to ride the proverbial bicycle: Either we keep moving forward or we risk falling off.

A final comment is in order. The Mexican crisis underscores how macroeconomic events can stand in the way of reaping the benefits of greater economic integration implied by agreements such as NAFTA. The peso crisis points to the need to continue monitoring macroeconomic events in Mexico and systematically analyze the impact of U.S. economic trends and policy decisions on the Mexican economy. Seeking a full-scale macroeconomic coordination between the two countries would be completely unrealistic at this point, but much could be accomplished by continuing the close consultations between the authorities of the two countries that developed in the context of the U.S. financial rescue package. Though the United States has no right to interfere with or to dictate Mexican macroeconomic policy (or vice versa), maintaining such consultations could help prevent another crisis or, at the very least, give some warning that one might happen.