NAFTA and Mexico's current economic crisis: Short-run and long-run perspectives

NAFTA and Mexico’s Current Economic Crisis: Short-Run and Long-Run Perspectives

JAMES PEACH* New Mexico State University

Policy-makers in both Mexico and the U.S. reacted to the economic crisis which began in Mexico in December, 1994 as if it were a problem of short-run financial liquidity. The argument presented in this article is that Mexico’s current crisis has its origins in long-standing, fundamental problems of the Mexican economy. These long-run problems include: massive external debt, a severely skewed income distribution, inadequate job creation, low productivity per worker and lack of investment in infrastructure. The short-run policy response will not address the long-run problems.

INTRODUCTION Four main propositions form the core of this article. First, Mexico’s current economic crisis has important consequences for the eventual success or failure of the North American Free Trade Agreement (NAFTA) and its possible extension to other nations (NAFTA-PLUS). Second, the Mexican crisis is not a short-run problem as asserted by both U.S. and Mexican policy-makers. The crisis in Mexico reflects long-term structural problems including employment generation, low productivity per worker, a large external debt, a highly skewed income distribution and inadequate investment in infrastructure. The third proposition follows logically from the second: the most recent financial aid package, which is based on a shortterm perspective, can at best provide only short-run stability to the Mexican economy. Fourth, it is possible to design appropriate policies within the framework of NAFTA to address Mexico’s long-term structural problems.

*Direct all correspondence to: James Peach, Department of Economics, New Mexico State University, P. 0. Box 3OOOl/Dept 3CQ, Las Cruces, New Mexico 88003. Telephone: (505) 646-3113. The Social Science Joumd, Volume 32, Number 4, pages 375-388. Copyright Q 1995 by JAI Press Inc. All rights of reproduction in any form reserved. ISSN: 0362-3319.

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The organization of the article is as follows. The next section contains a brief methodological note. Then I describe the origins of the current crisis from a shortterm perspective and examine the short-term consequences of the crisis and the policy response to the crisis. The following section makes the case that the current crisis reflects long-term structural problems. The last section outlines an alternative policy designed to alleviate Mexico’s long-term structural problems.

A METHODOLOGICAL

NOTE

The methodology used in this article consists of logical deductions based on elementary economic principles. The main concepts are from macroeconomic theory and international trade theory including exchange rate theory. These ideas are supplemented with selected facts from the recent economic history of Mexico. The concept of economic time is essential to the analysis. Economists make a fundamental distinction between short-run and long-run economic activity. In macroeconomics as well as microeconomics this distinction in timing is crucial since both the nature of the analysis and the policy implications that may be derived from the analysis will be affected. For example, macroeconomists use substantially different analytical tools to examine short-run fluctuations in economic activity (the business cycle) than they use to examine problems associated with long-run economic growth. Appropriate policy recommendations to cope with a recession (a short-run phenomenon) are very different from policy recommendations concerning long-run growth. During the NAFTA debate in 1993, proponents of the agreement frequently cited results from Computable General Equilibrium (CGE) models concerning the likely effects of the agreement.’ While the models differed in terms of specification and purpose, the authors of the models reached remarkably consistent macroeconomic conclusions. NAFTA, by lowering tariffs and increasing trade, would have positive effects on production, prices, and employment in the three nations. In relative terms, the CGE models predicted that the largest positive effects of NAFTA would be observed in Mexico. While CGE models were the analytical device of choice for many economists who examined the potential effects of NAFTA, these models have been strongly criticized and are inappropriate tools for an examination of the current crisis in the context of NAFTA. The models have been criticized particularly for their reliance on neoclassical theory which has a built in bias towards “free-trade.” It is difficult to imagine a neoclassical model indicating that there would be no gains from trade. Second, the models are essentially static (or comparative static) representations of a dynamic problem. Third, the estimation of the parameters of the models could not be accomplished with reference to data on a NAFTA-like free trade agreement-none had previously existed. Fourth, econometric models (CGE or not) are most likely to fail when they are most needed.2 That is, when conditions change rapidly (as in the current crisis) the models are least likely to be useful. Given the previous criticism of these models and the large shocks to the Mexican economy being considered here, no formal model will be developed.

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NAFTA and Mexico’s Current Economic Crisis

THE ORIGINS OF THE CRISIS: A SHORT-TERM

PERSPECTIVE

From a short-term perspective, the beginning of the Mexican crisis can be dated with considerable precision. On December 19, 1994 Mexican Treasury Secretary Jaime Serra announced that there would be a one time 14 percent adjustment in the pesodollar exchange rate. Because Mexico’s new President, Ernest0 Zedillo Ponce de Leon, (who took office on December 1) had previously announced that there would be no devaluation of the peso, Mr. Serra was careful to explain that this “adjustment” was not a devaluation.3 The peso, which had traded for between 3.0 and 3.4 to the dollar for most of the year, reached 4.0 to the dollar by the end of the next business day. Before the end of the month, it was apparent that the new exchange rate could not be maintained. By late January 1995, the peso fell to six to the dollar. The peso-dollar exchange rate reached a peak of slightly more than 7.0 in late February. By late May, the peso was selling for slightly less than 6.0 to the dollar. The large, sudden and apparently unanticipated devaluation of the peso signalled the start of Mexico’s current crisis. The devaluation was a highly visible symptom of the crisis but was neither the cause of the crisis nor Mexico’s most serious problem. An examination of the timing of the devaluation will shed light on this point. Purchasing power parity (PPP) theory can be used to examine the contention that the peso had been over-valued relative to the dollar for three or four years.4 As can be seen in Table 1, the peso-dollar exchange rate remained relatively stable between 1991 and 1994 even though the inflation rate in Mexico, as measured by the Consumer Price Index (CPI), averaged 15.1 percent annually while in the U.S. the CPI averaged only 4.6 percent per year. PPP theory suggests that, in the absence of intervention in foreign exchange markets, large inflation rate differentials will, at least eventually, lead to a currency depreciation in the nation with the higher inflation rate. The peso-dollar market was not, however, free of intervention. The Salinas Administration had two main reasons for wanting to avoid a major devaluation. First, during 1992 and especially during 1993 a major devaluation would have been a serious threat to the passage of NAFTA by the U.S. Congress. Second, after NAFTA had been passed by the U.S. Congress, Salinas had only a year remaining as president. He let it be known that he was seeking a job with an international organization, perhaps the newly formed World Trade Organization. A significant devaluation would have reduced his chances of obtaining such a position and would have, perhaps, permanently tarnished his image as a president who designed a successful economic recovery program. Perhaps there were other motivations for avoiding a devaluation. Direct Foreign Investment (DFI) in Mexico, mainly but not exclusively by U.S. firms, was a key ingredient in the Salinas Administration’s economic recovery program. While a devaluation would have made investment in Mexico “cheaper” for U.S. and other foreign firms, exchange rate instability might have created doubts about the “investment climate.” Another important part of the economic recovery program was wage and price stability.’ In all likelihood, a devaluation would have caused

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THE SOCIAL SCIENCEJOURNAL Table 7.

Vol.32/No.4/1995

Inflation and Exchange Rates in Mexico and the U.S. (1980-l 994)

Year

Exchange Rate’

CPI Mexico2

CPI u.s.3

i 980

23.3 26.2 115.2 120.1 167.8 256.9 611.8 1,378.2 2,273.l 2,461.5 2,812.6 3,018.4 3,094.l 3,115.2 3,451.6

29.9 28.7 98.8 80.8 59.2 63.8 105.2 159.2 51.7 19.7 29.9 18.8 11.9 8.0 7.1

13.5 10.3 6.2 3.2 4.3 3.6 1.9 3.7 4.1 4.8 5.4 4.2 3.0 3.0 2.7

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 ’ The exchange rate is expressed

in “old-pesos”

per dollar. In 1993,

Mexico

introduced

the ‘new peso’ with

1,000 old pesos

= 1 new peso. * This

column

is the annual percent change in the consumer

’ Seenote

2.

Sources:

The exchange rate and the CPI for Mexico of the International

of the President

Monetary

Fund’s

1994 and various

price index.

are from

International

Banco de Mexico,

financial

Uatisitics.

issues of the Survey of Current

The

lnforme

Anual

1993

and various

U.S. CPI is from The Economic

issues

Report

Business.

domestic (Mexican) prices to increase and, as a result, there would have been substantial pressure to increase wages. Whatever its exact motivations, the Mexican government attempted to maintain a controlled slide of the peso against the dollar throughout the early 1990s. Despite a large current account deficit, the Salinas Administration was able to avoid a major devaluation.6 As late as April 1,1994, the Mexican Treasury and Central Bank (Banco de Mexico) held $25.8 billion in foreign exchange reserves. The accumulation of these reserves had been possible despite the trade deficit largely because of foreign investment. When President Zedillo assumed office on December 1, 1994, Mexico’s foreign exchange reserves had declined to $6.2 billion.7 The nearly $20 billion dollar difference had been spent both on debt payments and maintaining the value of the peso. At the time (December 1994) Mexico faced large dollar denominated debt payments and could no longer spend its foreign exchange reserves to stabilize the exchange rate. As indicated above, the exchange rate began to fall almost immediately after Treasury Secretary Serra’s announcement of December 19, 1994. Mexican stock prices also fell sharply in late 1994 and early 1995 while interest rates and prices began an equally impressive increase.

The Short-term Policy Response Economic turmoil in Mexico was unpleasant and unanticipated news to U.S. policymakers. Only days before Serra’s December 19, 1994 announcement of the

NAFTA and Mexico’s Current Economic Crisis

379

“adjustment”in the peso-dollar exchange rate, the participants at a high level policy meeting praised Mexico’s economic stability and economic policies. The participants at the meeting included the usual suspects. Representatives from the U.S. and Mexican Departments of Treasury, the World Bank, the Interamerican Development Bank, the Federal Reserve Bank and other institutions attended the meeting and apparently were in general agreement on Mexico’s economic turnaround from the mid-1980s. Nevertheless, by early January, 1995 it was obvious that a problem existed in Mexico and that a U.S. policy response was required. The NAFTA-related consequences of the crisis were apparent. The Bush and Clinton Administrations had strongly endorsed NAFTA and had worked diligently for Congressional approval of the agreement. Both administrations claimed that NAFTA would result in increased U.S. exports to Mexico and a net increase in U.S. employment. There would be NAFTA benefits for Mexico as well. Improving economic conditions in Mexico might even lead to a decrease in Mexican migration to the U.S. The Clinton Administration was so convinced of the beneficial effects of NAFTA that it had endorsed the concept of extending NAFTA to include other nations. The Mexican crisis posed an immediate threat to the validity of the assumptions about the effects of NAFTA. The short-run consequences of the Mexican crisis will be examined in a later section of the article. For now, it is enough to note that the Clinton Administration was sufficiently concerned to propose a U.S. sponsored financial aid package for Mexico. The degree of the Administration’s concern was evident in both the size of the financial aid package (approximately 47 billion U.S. dollars) and its willingness to act on its own when Congressional approval of the package appeared doubtful. The details of the financial aid package and statements by U.S. Treasury Department officials confirm the short-term perspective on which it is based.g The key assumption in the design of the package was that Mexico faced a “short-term liquidity crisis” but that the “fundamentals” of the Mexican economy were sound. In short, there were no long-run structural problems requiring attention. The aid package consisted of two main components. First, loans from several sources were intended to stabilize the peso and to allow Mexico to restructure its dollar denominated external debt. The total amount of the loans was approximately $47 billion.” As announced, the U.S. was to provide twenty billion dollars from the Economic Stabilization Fund (ESF), the International Monetary Fund (IMF) agreed to provide $17 billion and the Bank for International Settlements agreed in principle to provide $10 billion. The loans were not to be used directly to intervene in exchange markets. Exchange rate stability would be restored when “the market recognized” that Mexico would not default on its external loan obligations and that the “sound” economic policies, required by the second major part of the package, had been implemented. The second part of the aid package was an agreement by Mexico to implement certain economic policies. These included a balanced federal budget, a rate of growth of the money supply lower than the rate of inflation, the sale of additional state-owned enterprises over a three year period, and a requirement that PEMEX (Mexico’s national petroleum company) deposit receipts from the sale of petroleum

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products into the U.S. Federal Reserve Bank in New York. Like the loans, the policy requirements of the package were based on a short-term perspective of the crisis.

Short-term Consequences Before presenting the case that Mexico’s crisis involves long-term structural problems, it will be useful to examine the short-term economic consequences of the crisis and the policy response to the crisis. The devaluation altered trade flows among the NAFTA nations, most notably between the U.S. and Mexico. The general direction of change in U.S.-Mexico trade flows after the devaluation could be anticipated with reasonable confidence. The devaluation resulted in higher (peso) prices for U.S. goods and services in Mexico and lower (U.S. dollar) prices for Mexican goods and services imported into the U.S. As a result, a decrease in U.S. exports to Mexico and an increase in U.S. imports from Mexico were to be expected. However, the change in trade flows after a devaluation can not generally be predicted with quantitative precision. There are many reasons why the change in trade flows will not be directly proportional to the magnitude of the devaluation. These include, but are not limited to, the price elasticities and cross-price elasticities of the traded goods and services and perhaps also the psychological reactions of consumers and investors. In 1994, the U.S. trade surplus in goods and services with Mexico was 691 million dollars (Table 2). During the first quarter of 1995 the U.S. trade deficit with Mexico was 3.8 billion dollars. Arithmetically, the U.S. merchandise trade deficit with Mexico was dominated by an increase in U.S. imports from Mexico (Table 2). Compared to the first quarter of 1994, the 1995 figures reflect a relatively modest decline in U.S. exports to Mexico. Nevertheless, the concerns of the Clinton Administration were warranted. The first quarter 1995 trade deficit with Mexico accounted for nearly 10 percent of the total U.S. trade deficit of $39 billion. The economic implications for Mexico of the financial aid package and its corollary economic policy restrictions may be examined in the context of a simple macroeconomic equation.

Y=C+Z+G+X-A4 where,

Y= C= Z= G= X = M =

(1)

national income (GDP) Consumption Investment Government Spending Exports and, Imports.

After the devaluation, the consumption component of this macroeconomic accounting identity is likely to decline. There are several reasons for the decline in consumption including a higher inflation rate, increased unemployment and a fifty percent increase in the Value Added Tax (from 10 to 15 percent) in Mexico

381

NAFTA and Mexico’s Current Economic Crisis

Table 2.

United States Merchandise Trade with Mexico: 1979-l 992 imports

Year

Notes:

Exports

Balance

1979

8,801

9,931

1,130

1980

12,580

15,197

2,617

1981

13,767

18,207

4,440

1982

15,557

11,749

-3,808

1983

16,774

9,081

-7,693

1984

18,039

12,037

-6,002

1985

19,104

13,386

-5,718

1986

17,164

12,363

-4,801

1987

20,295

14,590

-5,705

1988

23,325

20,573

-2,752

1989

27,099

24,671

-2,428

1990

30,495

28,103

-2,392

1991

31,526

33,137

1,611

1992

35,588

40,469

4,881

1993

40,428

41,478

1,050

1994

50,737

50,046

1995*

14,976

11,157

691 -3,879

All data in millions of current dollars. * 1995 data are for the first quarter only.

Source:

U.S. Department

of Commerce, “Survey of Current

the Census, Report FT900,

Business,” Various Issues and U.S. Bureau of

May 18, 1995.

implemented in March, 1995. The inflation rate in Mexico increased significantly as a result of the devaluation. The Government of Mexico now expects the CPI to increase by 42 percent during 1995, compared to 7 percent in 1994.” At the same time, the Zedillo Administration hopes to keep wage increases to ten percent or less for the year. In addition, interest rates for consumer loans have increased significantly. By March 1995, mortgage interest rates were reported as high as 100 percent per year and auto loans were reportedly as high as 80 percent per year.‘* The combination of these factors as well as general economic uncertainty are likely to result in a decline in consumption. Investment (I) is also likely to decline. Domestic investors in Mexico will react to the general economic uncertainty, the decline in consumption, and the steep rise in interest rates by delaying or canceling investment plans. Foreign investors may find the dollar price of Mexican investments to be lower, but could easily be discouraged from investing because of economic and political uncertainty in Mexico. Government spending (G) is unlikely to increase given Mexico’s agreement as part of the financial aid package to maintain a balanced federal budget. Since 1989, Mexico has managed to balance its federal budget primarily by selling state-owned enterprises, but this cannot be a continuing major revenue source. Moreover, Mexico’s entry into the GATT and later the NAFTA has meant a sharp reduction in the potential for tariff revenue. Unlike C, I and G the last two variables in the equation (X = exports and M = imports), suggest an increase in Mexican GDP and its current account balance.

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As noted earlier, exports have increased, while imports have declined. On balance, C, I and G far outweigh X and M as a proportion of GDP so it is reasonable to assume that Mexican GDP will decline in 1995. There are no reliable estimates of the employment consequences of the crisis in either the U.S. or Mexico. Press reports indicate that as many as a million jobs may have been lost in Mexico during the first quarter of 1995. In the U.S. any job losses resulting from a decrease in U.S. exports to Mexico are likely to be small and regionally concentrated.i3 As with previous devaluations, the current crisis had an immediate impact on U.S. retail sales to Mexican consumers in the border region.

THE LONG-RUN

NATURE OF THE CRISIS

There is strong evidence that the current crisis in Mexico should be viewed from a long-run perspective instead of the short-term perspective reflected in the recent financial aid package. First, the Clinton Administration financial aid package to Mexico is the fourth such rescue attempt since August, 1982. If the crisis is merely a “short-term liquidity crisis” as policy-makers in both nations claim, why have so many repeat performances been necessary? Second, the problem of Mexico’s external dollar denominated debt remains as a serious macroeconomic problem. Third, Mexico’s most pressing economic and social problems (job creation, income distribution and inadequate investment in infrastructure) have not been resolved by the financial aid packages or the widely acclaimed “structural reforms” of the 1980s and early 1990s. These three major long-run concerns are the focus of this section. The four financial aid packages of the 1980s and 1990s were designed to address two related problems: exchange rate instability and Mexico’s external debt. A brief review of the historical context in which these events occurred is useful. From 1954 to 1975, the peso-dollar exchange rate was fixed at 12.5 pesos per dollar. At that time, Import Substitution Industrialization (ISI) was the main feature of Mexico’s development strategy. While IS1 is now widely criticized, Mexico’s real gross domestic product increased at such a rapid rate (6.2 percent per year from 1954 to 1975) that many economists began referring to the “Mexican economic miracle.“14 Though Mexico was not exempt from periodic recessions, the high growth rate of GDP and generally low inflation rates meant that exchange rate stability was a luxury that Mexico could afford. In 1976, the cumulative effects of trade deficits and a rising inflation rate caused Mexico to devalue the peso to about 22 to the U.S. dollar. The 1976 devaluation was an unwelcome signal that not all was well with Mexican macroeconomic policy but Mexico did not abandon its long-standing commitment to fixed exchange rates or ISI. With recent major oil discoveries, rising oil prices and real GDP growth rates among the highest in the world, there seemed little reason to do so. These seemingly favorable economic indicators allowed Mexico to borrow large sums from international (mainly U.S.) financial institutions to finance its ambitious industrialization plans. By February 1982 Mexico could no longer intervene effectively in exchange markets to support the peso. The peso fell from 26 to the dollar to 45 to the dollar

NAFTA

and Mexico’s Current Economic Crisis

383

in the span of a week. In August 1982, Mexico announced that it could not meet its debt payments and the first of a series of “short-term liquidity crises” followed. A combination of rapid inflation, falling oil prices and high debt levels made it impossible for Mexico to support either the peso or to pay its external debt. In the U.S. the Reagan administration reacted quickly and with great concern. The U.S. was in the midst of its own “liquidity crisis” and several of the largest U.S. banks held enough Mexican debt that a default on these loans was perceived as a threat to the stability of the U.S. banking system. In cooperation with the Federal Reserve System, the U.S. Treasury Department, the Government of Mexico and several large U.S. banks, a plan was quickly devised to “restructure” Mexico’s loans. This was the first of four U.S. sponsored financial “bailouts”of Mexico from 1982 to 1995. In 1985, the Reagan Administration recognized that Mexico was once again having trouble meeting its loan obligations and again the peso was falling. To avoid another potential default, the Reagan Administration devised the Baker Plan named after then U.S. Treasury Secretary James Baker. The Baker Plan consisted of approximately $10 billion in loans to Mexico.” The IMF obligated U.S.$ 1.5 billion, the U.S. pledged $3.5 billion and various U.S. private banks agreed to provide a combination of restructured existing loans and new loans totaling $6.0 billion. The Baker plan became the second major U.S. financial aid package to Mexico. In 1988, Mexico was again in financial trouble. The Brady Plan, named after another U.S. Treasury Secretary, Nicholas Brady, was conceived during the last few months of the Reagan Administration and implemented during the first few months of the Bush Administration. No dollar amount can be accurately assigned to the Brady Plan, which involved a complex set of debt swaps and loan guarantees. The three financial aid packages of the 198Os, while differing considerably in detail, had much in common. Collectively, the three plans required Mexico to implement “structural” economic reforms as a prerequisite for U.S. and IMF aid. Mexico was required or strongly encouraged to reduce government spending, open its economy to foreign trade by lowering tariff and non-tariff barriers, allow greater foreign investment and ownership of previously prohibited assets, reduce the rate of growth of the money supply, reduce government subsidies to both individuals and businesses and sell many state-owned enterprises. Two Mexican presidents (Miguel de la Madrid, 1982-1988, and Carlos Salinas, 1988-1994) were ideologically receptive to such reforms and quickly made them their own. ISI had been abandoned in favor of an export-led, market-oriented development strategy. The underlying assumption behind the reforms of the 1980s was simple. By “privatizing the economy” and “unleashing market forces” Mexico would enjoy a great increase in productivity and the benefits of rapid economic growth. Mexico would then be able to compete effectively in international as well as domestic markets. The problems of inflation, exchange rate instability and debt repayment would be solved. This is not the place to debate the efficacy of the Mexican reforms of the 1980s. Some of the reforms were probably needed. Few could argue, for example, that many of the state-owned enterprises in Mexico did not need improvements in

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efficiency.‘6 No matter how the reforms are ultimately evaluated, it is clear that they had some costly side-effects. From 1982 to 1988 real GDP per capita in Mexico declined. In 1986, inflation as measured by the CPI reached 159 percent and many analysts thought that this figure understated the “true” rate of inflation. Despite the economic reforms and the financial aid packages, Mexico’s external debt problem continued. The Interamerican Development Bank reports that Mexico’s public external debt was 53 percent of GDP in 1993, barely a percentage point less than in 1984.17What restructuring means is that current debt is replaced by new, often larger, debt obligations. As argued earlier, the immediate cause of Mexico’s current crisis was its inability to simultaneously support the peso and meet its external debt obligations. In short, the Mexican crisis that began in late 1994 was not a “short-term liquidity problem” nor was it a new phenomenon. Mexico faced the same kind of debt related crisis repeatedly during the 1980s and Mexico’s debt problems can be traced back much farther.‘* Mexico’s most pressing macroeconomic problem is not, however, its large external debt. Throughout the 1990s and beyond, Mexico needs to create between 1.0 and 1.2 million new jobs per year simply to absorb new entrants into the labor market.” While the projections of new entrants to the labor market vary somewhat depending on the assumptions made, these figures do not deserve the scorn or ridicule properly attributed to many economic projections. The age-sex distribution of the population of Mexico is the starting point for all such projections. In 1990, 46 percent of Mexico’s population of 82 million were below the age of fifteen. Between 1.5 and 1.8 million people will reach the age of fifteen each year for at least a decade. Only a small portion of these young people will die or emigrate from Mexico. About 60 percent of the rest (between 1.0 and 1.2 million) will enter the labor market each year unless Mexico’s labor force participation rate changes significantly. To place such labor market data in perspective, consider employment in the maquila industry. The maquila industry, which began in 1965 and is often cited as Mexico’s most dynamic industry, employed nearly 600,000 persons in 1994.20 After thirty years, Mexico’s allegedly most dynamic industry has directly created only half of the jobs Mexico needs to create each year. Even with a generously estimated employment multiplier, Mexico needs a new maquila industry every year for the next several years simply to maintain the current level of unemployment and underemployment.2’ Mexico’s failure to create enough jobs to absorb new entrants into the labor market is a contributing factor to, but not the sole cause of, Mexico’s highly unequal income distribution. Income inequality is a long-standing problem in Mexico.22 Indeed, income inequality was, at the very least, a contributing factor to the Mexican Revolution (1910-1920). Lustig (1992) cites survey data indicating that the lowest forty percent of the income distribution received 12.9 percent of total income, while the top ten percent received 37.9 percent of total income in 1989.23 There can be no doubt that the economic difficulties in Mexico in the 1980s and 1990s have resulted in greater income inequality.24 In addition to imposing significant social costs on the people of Mexico, a high degree of income inequality effectively reduces domestic demand for a variety of

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385

consumer products. In turn, a smaller than necessary domestic market places limits on the ability of Mexican firms to take advantage of economies of scale and, thereby, reduces investment opportunities. In the context of NAFTA, income inequality is particularly important. Income inequality not only reduces the size of the market for domestically produced products, it also reduces Mexican demand for goods and services imported from the other NAFTA nations. Moreover, the same effect makes foreign investment in Mexico less attractive. Inadequate public investment is also an important issue in the context of both NAFTA and the problems of external debt, employment creation and income distribution. NAFTA means that Mexican industry must be able to produce and distribute its products as efficiently as firms in the U.S. and Canada. This will require substantial public as well as private investment. Consider, for example, Mexico’s transportation system.25 A highly efficient industrial system in a geographically large nation requires a modern and efficient transportation system. In Mexico, all modes of transportation (roads, rail, air, seaports and urban transit) have suffered in recent decades from inadequate investment.26 The result is that Mexico’s transportation system relies heavily on antiquated technology and is generally inefficient in moving either goods or people. An inefficient transportation system contributes to the inefficiency of Mexican industry and also to the concentration of industrial location in a few large urban centers. And, with NAFTA Mexico’s transportation system will increasingly need to interact smoothly with a broader international transportation system. Inadequate investment in Mexico’s transportation system is related to Mexico’s other long run problems. Decades of neglect mean that there is no real alternative to large scale public investment in transportation. Yet Mexico’s ability to do so is limited by its external debt and its recently abandoned policy of spending public funds to maintain exchange rate stability. A large public expenditure program on transportation would not only increase the efficiency of the transportation system and Mexican industry, it could also be a mechanism for creating jobs and to some extent improving its income distribution. The vicious circle of cumulative causation is complete. A high degree of income inequality reduces Mexican demand for both imported and domestic products and reduces both domestic and foreign investment opportunities. As a result, Mexico’s ability to create employment opportunities, increase productivity per worker, and ultimately to meet its international debt obligations is also reduced.

An Alternative Policy Perspective If, as argued above, the current crisis in Mexico is a reflection of both long-term and short-term problems, policies designed to alleviate the short-term problems are inadequate. Perhaps the most recent financial aid package will achieve its shortterm goals of economic stability-defined narrowly to mean stability in selected economic variables such as the peso-dollar exchange rate, the Mexican inflation rate, etc. There is some evidence to indicate that this is the case. There is virtually no evidence to suggest that the “fundamentals” of the Mexican economy are sound

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or that there will not be another “short-term liquidity crisis” in a few more months or a few more years. Policies can be designed within the framework of NAFTA to address both the short-term and long-term problems of the Mexican economy. The four main policy instruments outlined below are intended to be illustrative rather than exhaustive. (1) A Role for NADBANK. A short-term policy response to the current crisis in Mexico may have been necessary given the fact that Mexico had failed to address its long-term structural problems earlier (say ten or twenty years ago). In the context of NAFTA, it seems appropriate that financial aid to alleviate Mexico’s short-term problems should have been channeled through an adequately capitalized North American Development Bank (NADBANK). The NADBANK was established as a by-product of the NAFTA negotiations. NADBANK’s visibility and credibility as a NAFTA-related institution would have been enhanced considerably if it had been allowed to play a major role in the current crisis. This added visibility might also have spread-effects to other NAFTA-related organizations such as the Binational Environmental Cooperation Commission (BECC). Any future shortterm financial aid to Mexico should be channeled through NADBANK. (2) Independent Mexican Macroeconomic Policy. The U.S. should recognize that despite NAFTA, Mexico is a sovereign nation fully capable of designing its own macroeconomic policies. The macroeconomic conditions imposed on Mexico as part of the most recent financial aid package are at best counterproductive. This is especially the case regarding the requirement that Mexico balance its federal budget. As has been argued above, Mexico’s need for substantial growth in real GDP per capita is hampered in the short-term by a balanced budget requirement. Moreover, the irony of the U.S. requiring another nation to balance its budget is probably not lost in Mexico. (3) Realistic Debt Adjustment Policy. There is no possibility that Mexico can pay its external debt and simultaneously make the large-scale investments needed to achieve an adequate long-run growth rate in per capita GDP. No method of restructuring or refinancing the debt will solve the problem. Mexico’s external debt, both public and private, must be abolished-and the sooner, the better. Admittedly, the debt problem is difficult to solve. Both lenders and borrowers object to debt forgiveness but Mexico’s debt problem is neither unprecedented nor impossible to solve. One possibility is to let NADBANK assume responsibility for the Mexico’s external debt. NADBANK cannot pay the debt any easier than Mexico could. NADBANK could, however, placate debt holders by issuing 100 (or 200) year noninterest-bearing bonds for the face value of the debt. These bonds could be sold by current debt-holders at an appropriate discount. If NADBANK could not redeem the bonds when due, a distinct possibility, it could issue new bonds. Such an arrangement is not too different from some of the more elaborate debt-swap schemes already in place. The primary advantage of the arrangement would be to relieve Mexico of further obligation on its current levels of debt. (4) A NAFTA-based Marshall Plan. Mexico needs large scale, long-term, public and private investment from both international and domestic sources. NAFTA provides the opportunity to initiate a modern day equivalent of the Marshall plan.

NAFTA and Mexico’s Current

387

Economic Crisis

The necessary

funds, technology and expertise could be channelled through a NAFTA organization such as NADBANK. Such a plan would necessarily involve commitments from all three NAFTA nations. With appropriate incentives and guarantees private sector involvement in (and support of) the plan could also be assured. Surely, this would be a better expenditure of funds than a continuing series of short term financial aid packages. The policy alternatives outlined above do not directly address Mexico’s income distribution problem. Since I have argued in favor of an independent Mexican macroeconomic policy, it is inconsistent to argue that Mexico should adopt externally imposed income redistribution policies. Consistency is not always a virtue. Perhaps Mexico will voluntarily address its income distribution problem. More likely it will not. The U.S. has not been reluctant to force Mexico to adopt other policies, including policies that have contributed to income inequality. Why should the U.S. be reluctant to impose an income redistribution policy on Mexico as a condition for other forms of aid as outlined above?

NOTES 1.

U.S. International Trade Commission, Economy-wide Modeling of the Economic Implications of A FTA with Mexico and a NAFTA with Canada and Mexico, Report on Investigation No. 332-317 Under Section 332 of the Tariff Act of 1930, Washington,

DC (May 1992). 2. 3.

4.

5. 6.

7. 8. 9. 10.

11.

Wendell C. Gordon and John Adams, Economics as Social Science: An Evolutionary Approach (Riverdale, MD: Riverdale Press, 1989), pp. 169-176. Serra’s statement that the “adjustment” was not a devaluation was greeted with much amusement in the press and he was forced to resign. Guillermo Ortiz was quickly named to replace Serra as Treasury Secretary. Exchange rate determination is a complex and unsettled issue. PPP theory, either relative or absolute, has a less than perfect record of predicting exchange rates. See Mark Taylor, “The Economics of Exchange Rates,” Journal of Economic Literature, XXX111 (1995): 13-47, for a recent review of the literature and empirical research on exchange rate determination. Wage and price stability was the main feature of The Economic Solidarity Pact agreed to by the Salinas Administration, business leaders, and labor leaders in 1992. Mexico’s current account was in deficit from 1988 through 1994 according to the International Monetary Fund. Source: IMF, International Financial Statistics, 1994 Yearbook and the May 1995 issue. “International Monetary Fund,” International Financial Statistics, XLVIII (5, 1995): 380-381. “Washington’s Siesta,” Washington Post Weekly, Feb 20, 1995, pp. 8-9. U.S. Department of the Treasury, “Press Release and Transcript of Press Briefing,” Washington, DC, February 21, 1995. It is not clear exactly what U.S. Secretary of the Treasury Rubin and Mexican Treasury Secretary Ortiz signed. No copy of the agreement is available from the Treasury Department. The information presented here is taken mainly from the previously cited U.S. Treasury Department Press Briefing (February 21, 1995). XEJ-TV, News Broadcasts, Various dates, Cd. Juarez, Mexico.

388

12.

THE SOCIAL SCIENCE JOURNAL Vol. 32/No. 411995

No Author, “Mexican Consumers Lose with Peso Devaluation,” Norte-Sur, 3 (18, 1995): 1. 13. See, for example, Kelly A. George and Lori L. Taylor, “The Role of Merchandise Exports to Mexico in the Pattern of Texas Employment,” Economic Review of the Federal Reserve Bank of Dallas (First Quarter), 1995, pp. 22-30. 14. For a discussion of the Mexican economic miracle, see Robert Looney, Development Alternatives of Mexico: Beyond the 1980s (New York: Praeger Publishers, 1982). 15. For a discussion of the Baker Plan, see Jerry. R. Ladman, Mexico: A Country in Crisis (El Paso: Texas Western Press, 1986). 16. See, for example, James M. Cypher, State and Capital in Mexico: Development Policy since 1940 (Boulder: Westview Press, 1990). 17. Interamerican Development Bank, Economic and Social Progress in Latin America: 1994, Washington, DC. 18. For a discussion of Latin American debt during the last century, see Paul W. Drake, ed., Money Doctors, Foreign Debts and Economic Reforms in Latin America from the 1890s to the Present (Wilmington: Scholarly Resources, Inc., 1994). 19. See, (1) Manuel Garcia y Griego, “The Mexican Labor Supply, 1990-2010,“in Mexican Migration to the United States: Origins, Consequences, and Policy Options, edited by Wayne A. Cornelius and Jorge A. Bustamante (San Diego: University of California, Center for U.S.-Mexican Studies, 1989), pp. 49-93; (2) James D. Williams and Clyde Eastman, “The Changing Population at Labor Force Ages Along the U.S.-Mexico Border,” Journal of Borderlands Studies, IX (2)(1994): 2345; and (3) Benjamin S. Bradshaw and W. Parker Frisbie, “Potential Labor Force Supply and Replacement in Mexico and the States of the Mexican Cessation and Texas: 1980-2000,” International Migration Review, 17(3)( 1976): 394-409. 20. Instituto National de Estadistica, GeografIa e Informatica. Avance de information Econbmica Industria Maqualadora de Exportation (June 1994). 21. For a very different view of the Mexican labor market, see Peter Gregory, Z7re Myth of Market Failure: Employment and the Labor Market in Mexico (Baltimore: Johns Hopkins University Press, 1986). 22. Clark Reynolds, l%e Mexican Economy: Twentieth Century Structure and Growth (New Haven: Yale University Press, 1970). Nora Lustig, Mexico: The Remaking of an Economy (Washington, DC: Brookings Institution, 1992). 23. Nora Lustig, Mexico: The Remaking of an Economy (Washington, DC: The Brookings Institution, 1992), p. 92. 24. See, for example, Miguel D. Ramirez, “The Social and Economic Consequences of the National Austerity Program in Mexico,” in Paying the Costs of Austerity in Latin America, edited by Howard Handelman and Werner Baer (Boulder: Westview Press, 1989), pp. 143-170. 25. Other obvious examples include technical and vocational training, education and the health care system. 26. See David J. Molina and James R. Giermanski, Linking or Isolating International Economies: A Look at Trucking Along the Texas-Mexico Border (Austin: Lyndon B. Johnson School of Public Affairs, 1994).