July 1, 1990

July 1, 1990 | Lecture on Trade, Economic Freedom

Promoting Prosperity Through a U.S. -Mexico Free Trade Area

(Archived document, may contain errors)

Promoting Prosperity Through A U.S.-Mexico Free Trade Area

By Edward 1. Hudgins, Ph.D. During the last decade the debt crisis in less developed countri es and the threat of in- creased trade protectionism were the two most serious international economic problems. The spark that set off the crisis was the default of the Mexican government in August 1982. The crisis developed and was fueled, in Mexico as w e ll as in other debtor countries, in part by trade protectionism. Restrictions on imports meant low productivity for Mexican in- dustries and massive government subsidies to state-owned enterprises that tried to make up, in an extremely inefficient manner, for lost imports. Ile result was massive government borrowing. In addition, trade restrictions in developed countries, including the United States, closed markets for goods from Mexico and other debtor countries. Now, Mexican President Carlos Salinas de G o rtari has asked the U.S. to open talks on a Free Trade Area (FTA) between the two countries. The Bush Administration not only has wisely accepted this offer but has suggested a Western Hemisphere FTA. It is appropriate that with his FTA request, President Salinas will help deal with his country's debt and trade problems, and take a giant step in assuring Mexico's future economic growth and prosperity. Further, an FTA will create jobs in Mexico, reducing in part the exodus of Mexicans to the U.S. Finally, i t will force Mexicans to invest only in their most productive industries. Less money will be wasted on inefficient enterprises hiding behind a wall of protection. Incentives for Others. Ile U.S. also will gain from such an FTA with Mexico. More American go o ds and services will be sold in Mexico. American consumers will have greater free access to Mexican products. Further, a U.S.-Mexico FTA will create greater incentives for other countries to seek bilateral open markets with the U.S. The Israel and Canada F TAs with the U.S. have created pressures for more free trade. An F17A with Mexico will bring us one step closer to complete open markets in North America, the Western Hemi- sphere, and perhaps throughout the world. President Salinas showed wisdom and cour a ge in seeking a Free Trade Area with the U.S. The Bush Administration has been equally wise in offering to negotiate FTAs with any country in the Hemisphere that seeks one. The Administration should extend this offer to Asian countries such as the Republi c of China on Taiwan and Singapore. And if Congress wishes to help the U.S. and these other countries, it will give these arrangements their full support.

Edward L Hudgins, Ph.D. is Director of The Heritage Foundation's Center for International Economic Gro wth. This is his June 28, 1990, testimony before the Subcommittees on Western Hemisphere Affairs and Economic Policy and Trade of the House Foreign Affairs Committee. ISSN 0272-1155. 01990 by The Heritage Foundation.

America's Interests In Mexico The hi story of U.S.-Mexican political and economic relations has been troubled.Me last century saw war over territory and U.S. military intervention in Mexico. A major goal of the Mexican Revolution of 1910 was to reduce what was perceived by Mexicans as excess i ve American investments and thus excessive political influence in their country. Mexico nation- allzed most foreign enterprises and set strict limits on foreign investments. In general, for- eigners generally were allowed to own only 49 percent of a busin e ss. This meant that the Mexican government often had to provide investment capital for industries and thus often had to borrow money or inflate the currency. Further, Mexico erected trade barriers to foster the development of its domestic industries. This resulted in inefficient industries, since they did not have to compete in world markets, and low levels of economic output. Many industries were owned by the government and required heavy subsidies to meet ex- penses. This meant more borrowing or currency inflation by the Mexican government. Thus, Mexico's trade protection was a major contributing factor to the debt crisis. But the problem has not only been on Mexico's side of the border. American trade protection for products such as textiles and apparel p roducts robbed Mexico of markets for its goods. And in general, trade protection in developed countries has harmed the poorer countries. A February 1989 study by the U.S. Agency for International Development on "Development and the National Interest" foun d that all the foreign aid given by richer countries does not quite cover the damage done by their protectionist policies to less developed countries. Yet despite past troubled relations, with the exception of the Soviet Union, no country is of greater imp o rtance to the U.S. than Mexico. Its 80 million people and two-thousand-mile border with the U.S. mean that Mexico's problems are America's problems. The U.S. has a three-fold interest in an economically prosperous Mexico. First, a poverty- stricken Mexico is likely to be politically unstable. The rise of an anti-American, pro-com- munist regime South of the Border would be a major security disaster for the U.S. A prosperous Mexico likely would be politically stable and friendly to America. Second, America h as a humanitarian interest in seeing the elimination the destitution that is characteristic of the lives of too many Mexicans. The average Mexican has only about one-tenth the annual income of an American. Third, an economically prosperous Mexico is bette r able to purchase American products and to supply goods to the U.S. market. U.S.-Mexico Trade Relations

T'he U.S. and Mexico already have a close economic relationship.Me U.S. is Mexico's principal trading partner, last year absorbing some $25 billion, or about 60 percent, of Mexico's exports and providing $27.2 billion, or 65 percent, of Mexico's imports. America's third largest trading partner after Canada and Japan, Mexico receives 6 percent of U.S. ex- ports and sells America 6 percent of its imports. In recent years Mexico has taken major steps away from its closed market policies of the past. In 1986, Mexico joined the General Agreement on Tariffs and Trade (GATT), the in- ternational arrangement meant to foster open markets. As a result of this move , Mexico has


cut import tariffs from a high of 100 percent on some items to a maximum today of 20 per- cent. Most tariffs are far below this level, averaging about 9 percent. Further, Mexico has eliminated most import licenses. In addition, a special framework agreement signed with the U.S. in 1987 establishes joint working groups to deal with trade differences. Now Mexico is taking an even bolder step by seeking a Free Trade Area (FTA) with the U.S.

The Free Trade Area Approach Most trade between ov er 90 of the non-communist countries is governed by the GATT. The basic principle of the GATT is most favored nation (MFN) status. All GATT members agree that the lowest tariff rate charged on any given product will be charged to all other GATT members, e v en if their tariffs on this product are higher or lower than this amount. This makes international trade easier, since each country has one set of tariffs for all other GATT members. It also prevents trade wars in which tariffs on some given items are rai s ed on a particular country but not on others. Over the last decade, however, the GATT has been less able to cover non-tariff trade bar- riers.The current round of GATT negotiations, scheduled to end this year, will try to deal with some of these problems. Further, America's trade deficit has led to increased protec- tionism by the U.S. and trade tensions with other countries. An FTA moves beyond the GAT17 and allows two countries to remove all tariffs and many non-tariff trade barriers, such as quotas or l i censing requirements for domestic goods that discriminate against imports. Restrictions on foreign investments also could be eliminated. An FTA differs from a customs union in which the member countries have a uniform set of tariffs and trade laws applyin g to non-members. In an FTA, each member keeps its own set of trade regulations for non-members. An FTA also differs from a com- mon market. In addition to uniform trade laws towards non-members, workers in a com- mon market are free to move between member countries. Ile U.S. currently is phasing in over ten-year periods FTAs with Israel, which was ap- proved in 1985, and with Canada, which took effect in 1989. The debates in the U.S. and these countries over FTAs brought out many of the advantages of this s ort of arrangement. An FTA is bilateral. Both sides open their markets. It is therefore a "fair" trade. Both sides benefit. There is not a "winner" or a "loser." Both countries win. By allowing goods and ser- vices to be produced by the most efficient com p anies in member countries, FI`As help raise the GNP in both countries. Critics' Errors. Some critics maintain that an FTA will work only between countries at similar levels of economic development and with similar social and political institutions such as the U.S. and Canada. FTAs between developed and less developed countries such as the U.S. and Mexico, they argue, would not benefit both countries. The arguments specifically against a U.S.-Mexico FTA on both sides of the Rio Grande il- lustrate the error s of both groups of critics. Some Mexicans fear that opened markets will mean that the U.S., with a GNP of $5.5 trillion, would completely dominate Mexico's $150 billion economy. They assume that Mexican industries will be unable to compete with rich and t echnologically advanced American firms. Mexican businesses, they maintain, will shut down in the face of U.S. imports.


Ironically, American critics complain that an FTA with Mexico would doom many U.S. firms that would be unable to compete with the low wages available to Mexican enterprises. Further, they fear that as American investments move to Mexico and more American f ac- tories are established there, Americans will lose jobs. Complementary Economies. Both U.S. and Mexican critics are wrong.The economies of the U.S. and Mexico complement one another. Some American firms need access to inex- pensive Mexican labor in ord e r to lower their costs and remain competitive. Mexico needs American capital and technology to get its economy growing again. Both countries will gain jobs and additional GNP. A preview of the FTA benefits is found in the special U.S.-Mexico arrangement p o pularly known as the maquiladora system. Under this program, which gained momentum in the last decade, U.S. firms can establish wholly owned factories in Mexico, typically near the U.S.- Mexican border. Permitting Americans to own factories outright is an exception to the usual Mexican limit of 49 percent foreign ownership. The owners can import, duty-free, capital equipment, components, and raw -materials for their operations. The final products must be exported.The U.S. for its part, gives special tariff breaks to imports manufactured from American-made components. While a wide range of items are produced in the maquiladora plants, most factories as- semble semi-finished components. Example: the parts of a motor are assembled and the finished product ship p ed back to the parent company in the U.S. for direct sale to the con- sumer. Example: the carburetor for an engine is assembled in Mexico and returned to the parent company in the U.S. for inclusion in an automobile assembled in Detroit. Example: electron i c components are assembled in Mexico then sold and shipped to another U.S. enterprise for inclusion in a computer. 100,000 U.S. Jobs. This maquiladora system employs an estimated 350,000 Mexicans. Some 100,000 Americans work at jobs in the U.S. to supply t hese facilities. Without the ma- quiladora option, the U.S. probably would not "win" 350,000 jobs from Mexico. More than likely, the U.S. firms would move offshore entirely, perhaps to Asia, would contract their operations in the U.S., or would shut down. The U.S. might well lose all 100,000 jobs. In 1988 the U.S. Department of Ubor estimated that if America removed special tariff treat- ment for items manufactured overseas out of U.S. components, 1a key to the maquiladora trade, America would lose $2.6 bi l lion in GNP and 76,000 jobs. A recent survey by Grupo Bermudez of Ciudad Juarez, Mexico, found that 20,743 American enterprises in 49 states plus the District of Columbia supply components to ma- quiladora plants in just one Mexican city, Ciudad Juarez, w hich is across the border from El Paso, Texas. These suppliers generally are located in the Northeast and North Central in-

1 Greg Schoepfle and Jorge Perez-Lopez, U.S. Employment Impact of TSUS 80630 and 80700 Provisions and Medcan Maquiladdrus. A Survey of Issues and Estimates, Economic Discussion Paper No. 29, Bureau of International Labor Affairs, U.S. Department of Labor, August 1988.


dustrial U.S. states. The other top ten suppliers for Juarez are Texas with 4,911 suppliers, Ohio with 932, Michigan with 920, California with 882, New York with 784, Pennsylvania with 667, Indiana with 614, New Jersey with 530, and Wisconsin with 527. 2

The Benefits for the U.S.

An FTA with Mexico promises a number of economic benefits to the U.S. First and foremo st, opened markets would mean that American enterprises could sell more products South of the Border. Under the maquiladora arrangement, goods produced in American factories in Mexico must be re-exported and thus do not enter the Mexican economy. Products that the U.S. could sell would include telecommunications equipment, computers, machine tools, mining and construction equipment, electrical production and generating machinery, and food processing and packaging equipment. If an FTA includes the eliminati o n of U.S. import quotas, the American consumer would benefit from increased access to certain Mexican textile and apparel products among other goods. The U.S. also could be getting in on the ground floor of a new, fast growing economy. The FTA proposal is only one of the major changes made by President Salinas in his attempt to radically reform the Mexican economy. With the help of the FTA as well as other reforms, Mexico could become a fast growing economy, another South Korea or Thailand.

The Benefits fo r Mexico Mexico, in a sense, has the most to gain from an FTA since its economy is in far worse shape than is America's. Opened markets would give Mexican companies access to less ex- pensive, high quality capital goods. This would go a long way to helpin g Mexico increase its economic productivity and modernize its industries and infrastructure. In the end, purchas- ing power and higher living standards are a result of turning out the most goods and ser- vices per input of labor, capital, materials, energy , and equipment. Mexican prosperity thus is tied to Mexican productivity. If an FTA removes restriction on foreign investments in Mexico, as it should, then Mexico would, in the long term, receive much needed capital invested in existing enterprises or in n ew ones. Free movement of capital should be an essential part of a U.S.- Mexican FTA. An FTA also would give Mexican consumers access to certain American consumer products. In many less developed countries, governments try to limit imports to items deemed essential to production. This is a mistake. Economic reforms in less developed countries ultimately should offer individuals the opportunity to profit from their own ef- forts. Individuals work and seek better ways to serve the market demands of their fel low citizens not for the good of the state, but for their own good and that of their families. A salary means nothing if an individual has no access to the goods and services that makes his

2 Wiffiam L Mitchell and Lucinda Vargas, "Economic Impact of the Maquiladora Industry in Juarez, Mexico on El Paso, Texas and Other Sections of the United States," Grupo Bermudez, Ciudad Juarez, Mexico, 1987.


or her life better. Therefore a market opened to all products is an essential element for generating econom ic growth. And important point must be kept in mind about free trade. Generally, "countries" do not trade with one another. Individuals do. For both Mexicans and Americans, a free trade area simply reestablishes the right of individuals to dispose of thei r property as they see fit, to buy and sell based on mutual agreement. Creating Opportunities. An FTA also would create incentives for Mexicans to invest in enterprises that are truly competitive and to remove support from enterprises that can only survive behind a wall of protection. It will become more costly for Mexicans to keep open inefficient enterprises if they are subject to competition from imports. The Mexican govern- ment will find itself increasingly unable to supply the larger subsidies needed t o keep state enterprises in operation. An FTA will give Mexico free access to the U.S. market for its goods. This will create Op- portunities in many industries and will, in the long-term, more than offset the burdens of economic adjustment. Finally, an F T A will give Mexicans an incentive to stay and work in their own country rather than flee to the U.S. It is often said that Mexico either will export to the U.S. its goods or its people. And despite what is commonly believed, Mexico, not America, will gain from slower immigration into the U.S. The Mexicans going North are the most energetic and entrepreneurial, the ones that are willing to act and take risks to better their lives. These are just the sort of individuals that Mexico should want to keep.

Falla cies About Free Trade In both Mexico and the U.S., policy makers and the public as well hold a number of mis- taken beliefs about free trade. Many Mexicans, for example, worry that increased economic integration with American could result in undue influen c e over their politics. This concern is the result of the unfortunate history of U.S. intervention in Mexico. But in today's world, such influence is of less concern. For example, Canada feels free to oppose the U.S. on foreign policy matters even though A m ericans have $90 billion in direct and indirect invest- ments in Canada, own many businesses in Canada completely, and purchase the majority of Canadian exports. During the Vietnam War, for example, Canada accepted American draft dodgers with impunity. So m e critics of free trade on both sides of the border are concerned that wages in Mexico will remain low with greater American ownership of productive Mexican assets. Yet even now in the maquiladora factories, foreign owners have manpower shortages and atte m pt to attract workers with special benefits and bonuses. Mexican government wage guidelines are more responsible for keeping wages low. Further, the only permanent solution to low wages is higher productivity. The Asian countries of Hong Kong, South Korea , Singapore, and the Republic of China on Taiwan begun in such a situation but produced themselves to higher wages and living standards.


Momentum for Worldwide Open Markets Beyond the immediate economic benefits to the U.S. and Mexico, and FTA would create additional incentives for more open markets worldwide. In 1985 an opponent of free trade perhaps made the case best in favor of such arrangements. Testifying b efore Congress on an FTA with Israel, Stephen Koplan of the AFL-CIO said: If agreement can be reached and Congress approves, it would be the first such free trade arrangement in U.S. history. Its establishment would make future requests from other countri e s for free-trade areas much more difficult to refuse. The economic and political rationale given by the Administration for establishing a free-trade area with Israel will be cited as precedent by many other countries in the world. Is this initiative the s t art of the process where similar negotiations will soon commence with South Korea, the Philippines, or the European Economic Community? While this FTA opponent got the countries wrong, he correctly identified the momentum set up by FTAs. The U.S.-Israel F T A illustrates this point. Shortly before Israel and the U.S. entered FTA negotiations, Israel established substantial trade liberalization with the European Community. Without an FTA, U.S. products entering Israel subject to tariffs would have competed at a disadvantage against European goods subject to lower tariffs. Thus, the incentive for the U.S. was not to close its markets to Israeli goods in retaliation but rather to open Israel's market further to U.S. goods, in this case through an FTA. Japan's Co n cern. The FTA's potential dynamics were evident during then-Japanese Prime Minister Yasuhiro Nakasone's 1986 visit to Canada shortly after Washington and Ot- tawa announced their intention to open free trade talks. While publicly Nakasone expressed no res e rvations about the pact, behind the scenes Japanese officials were concerned about the effects of such an FIFA on sales of Japanese goods competing with U.S. goods in Canada. As Mexico began its trade liberalization with the U.S., the Japanese began to ta k e a much greater interest in that market. A year or two ago I had a conversation with business representatives from the Caribbean. They expressed some concern that if the U.S. established an FTA with the Mexico before establishing one with the Caribbean, t hat investments might go to Mexico rather than to the Caribbean. All of these examples illustrate the incentives created by FI7As for non-member countries to seek similar arrangements, countries competing to be the next to establish FrAs with the U.S. Thi s interest is spreading in this Hemisphere. Several years ago Uruguay asked the U.S. about what an FI7A would involve. Unfortunately, at that time the U.S. said that Uruguay's major exports, apparel products and agricultural goods, would probably be ex- cl u ded. An opportunity to demonstrate the U.S. commitment to open markets was missed. Recently, when asked about an open trading arrangement in North America and converting the Caribbean Basin Initiative into an FTA, Jamaican Prime Minister Michael Manley sa id he thought it would be inevitable. Argentina recently hinted that it might be interested in an FIFA. Chile has made a similar suggestion.


Invitation to All. The idea of a North American FrA including Mexico, Canada, the Caribbean, and Central Americ a has been discussed for some years. Now President Bush has showed true leadership and imagination by offering to negotiate a Western Hemisphere FrA. This proposal deserves the strongest support from Congress and from any citizen of this Hemisphere who wi s hes to give all people the opportunity for economic prosperity. The Administration, moreover, should extend the same free trade invitation to any Asian country that wishes such an arrangement. Currently, the Republic of China on Taiwan and Singapore are s e eking FTAs with the U.S. The goal of U.S. trade policy should be open markets in the U.S. and with all of our trad- ing partners. FTAs are an important tool in any free trade strategy. The U.S. therefore should offer to negotiate FTAs with any country tha t wishes to remove its own barriers to American imports in exchange for open U.S. markets.



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