Tuesday, January 31, 2017

The Reality of NAFTA

Trade is not a zero-sum game.

Neither trade nor negotiations are zero-sum games. Unfortunately, Mary Anastasia O’Grady in “President Trump’s Mexican Standoff” (1/30/2017 WALL STREET JOURNAL) misses that point. As a strong advocate of free trade and one who favored NAFTA consistently since its initial negotiation during the Bush administration, I commend her for her efforts to present the benefits of freer trade with Mexico. One of my complaints about Bill Clinton's run for the presidency was the hypocrisy in his campaigning against NAFTA and then claiming its signing as a major accomplishment. The hypocrisy of cultivating a distrust of free trade despite knowing that it is desirable has been a hallmark of Democratic politics. A legitimate concern is that the consistent failure of politicians to defend free-trade while demonizing those who do defend it has led to the election of a president who may not understand those benefits.

However, it is extremely important to present the benefits as well as the costs honestly. Much of the protectionist sentiment in America reflects a failure to honestly acknowledge both the costs and benefits. Thus, it is extremely important when trying to defend free-trade that the economics be clearly stated. The author’s presentation falls short of an honest presentation of the counter argument against the proposed tariff on Mexican exports. It is not honest to say that the 20% cost of the tariff would be paid by American consumers. Assuming no currency adjustment, the cost of the tariff will be distributed between consumers in the form of higher prices and producers in the form of lower output depending upon the elasticity of demand for the product. If the product is considered a “must have” by US consumers, they will pay the 20%. If the product is very discretionary, consumers will rebel against a 20% price increase and just do without the product. Mexican producers will suffer a loss of sales equal to that reduced consumption.

Also, the author’s presenting the fall in the Mexican peso as something the Trump administration would welcome is sheer nonsense. The perception that it strengthened Trump’s negotiating position seems to be based upon a perception that the objective of the negotiation is to win a zero-sum game where one side wins and the other loses. It makes no sense if the objective of the Trump administration is their professed desire for more balanced trade. The weaker peso makes Mexican exports more desirable to US consumers. It only increases the urgency of the administration's need to resolve the issue and constrains their flexibility in the negotiations. Not only does it weaken Trump’s position with respect to Mexico, it also weakens his position vis-à-vis Republican’s advocating a border adjustment tax instead of Trump’s approach. The drop in the peso is exactly the currency responses that advocates of the border adjustment tax say will eliminate any inflationary impact of their tax plans.

When presenting the benefits of free trade, economists can show that relative advantage results in all parties involved in free-trade being better off in aggregate. However, as is illustrated by the peso's adjustment, the theoretical underpinnings of the advantages of free trade are often illustrated by exclusively focusing on goods and services. In the real world there is an important additional commodity being traded: it is the currency.  It would behoove those thinking about what constitutes more balanced trade between the US and Mexico to keep in mind the fact that the dollar is a reserve currency. To the extent Mexico requires reserves it will need to export more to the US than it imports from the US. That's the only way Mexico can accumulate the dollars it needs to hold as a currency reserve. By contrast the US has no need to import pesos. Consequently, it's totally unrealistic to think that the US exports to Mexico should, or could, ever equal Mexico's exports to the US over a long period of time.

NAFTA should be evaluated based upon the extent to which it allows the free exchange of goods between willing parties. It's totally inappropriate to pretend that the balance of that exchange provides the criteria by which NAFTA can be evaluated. If the balance of trade is lopsided, it isn't due to the structure of free-trade. No country has a relative advantage in all things.

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