J ULY /AUGUST 1996 Christopher J. Neely is a research economist at the Federal Reserve Bank of St. Louis. Kent A. Koch provided research assistance. This article examines the relationship The Giant between NAFTA and the peso crisis of December 1994. First, the provisions of Sucking Sound: NAFTA are reviewed, and then the links between NAFTA and the peso crisis are Did NAFTA examined. Despite a blizzard of innuendo and intimation that there was an obvious Devour the link between the passage of NAFTA and Mexican Peso? the peso devaluation, NAFTA’s critics have not been clear as to what the link actually was. Examination of their argu- Christopher J. Neely ments and economic theory suggests two possibilities: that NAFTA caused the Mex- t the end of 1993 Mexico was touted ican authorities to manipulate and prop as a model for developing countries. up the value of the peso for political rea- A Five years of prudent fiscal and mone- sons or that NAFTA’s implementation tary policy had dramatically lowered its caused capital flows that brought the budget deficit and inflation rate and the peso down. Each hypothesis is investi- government had privatized many enter- gated in turn. prises that were formerly state-owned. To culminate this progress, Mexico was preparing to enter into the North American NAFTA Free Trade Agreement (NAFTA) with NAFTA grew out of the U.S.–Canadian Canada and the United States. But less than Free Trade Agreement of 1988.1 It was a year later, in December 1994, investors signed by Mexico, Canada, and the United sold their peso assets, the value of the Mex- States on December 17, 1992. The legisla- ican peso plunged 50 percent against the tures of those countries ratified NAFTA, U.S. Dollar, and Mexico was forced to bor- and the agreement took effect on January row from the International Monetary Fund 1, 1994. The treaty substantially lowered (IMF) and the United States to get through national barriers to trade and investment a financial crisis. In 1995, inflation in Mex- in North America, giving consumers more ico soared to 50 percent and real gross do- choices and lower prices. In addition, the mestic product (GDP) fell by 4 percent. changes began to lower the cost of produc- Politicians and commentators like Ross Perot, Pat Buchanan, William Greider, and tion and to funnel investment and labor to Robert Kuttner blamed the enactment of their most productive uses. Not surpris- NAFTA for the devaluation of the peso and ingly, the costs—real and imagined—of the ensuing economic turmoil in Mexico, this reallocation of resources stirred the with some calling for its renegotiation or passions of those opposing the agreement. even repeal. As the members of NAFTA The trade provisions of NAFTA were consider expanding to encompass other designed to reduce tariffs and nontariff Latin American nations, such as Chile, in- barriers—such as quotas and import vestors and policymakers should under- licensing—radically over 15 years. Some tariffs were reduced immediately, whereas stand the link between NAFTA and the 1 See Hufbauer and Schott peso crisis well. Did NAFTA cause or exac- other reductions will be phased in over a (1993), Aguilar (1993), or erbate the devaluation of the peso? Or did period of 10 years—15 years for certain Tornell and Esquivel (1995) NAFTA help alleviate some of the conse- sensitive sectors, such as agriculture and for more discussion of NAFTA’s quences of the crisis? textiles and apparel. provisions. F EDERAL R ESERVE B ANK OF S T. LOUIS 33 J ULY /AUGUST 1996 For the United States and Mexico, the Despite the impressive achievements trade provisions of NAFTA are expected to of the negotiators in crafting such a far- have their most important effects on the reaching trade agreement, NAFTA’s direct automobile, textile and apparel, and agri- economic benefit to the United States will cultural sectors. In agriculture, U.S. and likely be small. One representative esti- Mexican quotas were immediately con- mate of NAFTA’s annual benefits to Mex- verted into equivalent tariffs and those ico and the United States arrives at ap- tariffs will be phased out over 10 to 15 proximately the same figure for each years. As Hufbauer and Schott (1993) country;5 however, this amounts to about note, this is a remarkable achievement 0.3 percent of 1993 U.S. GDP but more given the difficulties encountered by than 5.0 percent of Mexico’s output. Schott other free trade agreements on agricul- (1994), Tornell and Esquivel (1995) and tural issues. others have argued that the most impor- Given the fierce fight in the United tant aspect of NAFTA’s passage for the States over the agreement, it is ironic that Mexican economy is that it would cement NAFTA required more substantial changes the other economic reforms in place. Krug- in Mexican law—both trade and invest- man (1993) and Orme (1993) both contend ment law—than it did in U.S. law. Average that NAFTA is most important to the United U.S. tariff levels on Mexican goods were States as a tool of foreign policy, to encour- already quite low—just four percent—on a age Mexican economic and political reform. value-weighted basis, before the introduc- tion of NAFTA.2 Mexican tariffs were higher, averaging 10 percent on imports NAFTA AND THE VALUE from the United States. Through NAFTA, OF THE PESO Mexico also committed itself to address This section lays out the case that the other long-standing U.S. concerns, like the peso was kept overvalued because of the pol- protection of intellectual property rights itics of NAFTA and then investigates whether and reform of Mexico’s regulation of for- this argument is consistent with the facts. eign investment. NAFTA was the culmination of a sig- The Case That the Peso’s Value nificant break with Mexico’s protectionist Was Artificially Inflated Because 3 past. Until the 1970s, Mexico followed a of the Politics of NAFTA 2 See Tornell and Esquivel policy of import substitution industrializa- tion that mandated highly protected mar- The most common hypothesis linking (1995). Changes in value- NAFTA to the peso crisis is that the politics kets for manufactured goods. In that weighted tariff schedules can of NAFTA caused the Bank of Mexico to decade, preliminary reforms in the direc- be misleading, however, be- systematically manipulate the value of the cause there are also some tion of freer trade were taken. The debt peso to increase support for the treaty, both quantitative restrictions. crisis of 1982 reversed that trend; for a before NAFTA was passed in the United 3 See Kehoe (1995) for a re- short period in 1982–1983, Mexico was States and during its first year. There are view of Mexico’s recent trade one of the most protected economies in two versions of this hypothesis. The first history. the world. During the de la Madrid admin- version suggests that the value of the peso istration (1982–88), Mexico took impor- 4 The GATT was an international was deliberately manipulated to secure po- organization to negotiate free tant steps to move toward more liberal litical support for NAFTA and that the de- trade among its members. It trade. Mexico lowered tariffs and joined valuation—to obtain a trade advantage— has been superseded by the the General Agreement on Tariffs and was planned well in advance. The second World Trade Organization Trade (GATT) in 1986.4 Mexico took fur- version is less sinister. It suggests only that (WTO). ther unilateral steps toward free trade as the Mexican authorities were sensitive to 5 Krugman (1993) and Brown, part of the Salinas administration’s U.S. politics in setting exchange rate policy Deardorf and Stern (1992) dis- (1988–94) program of economic reform. after NAFTA was passed. The following sec- cuss estimates of the gains This period is known as la apertura (the tions lay out the arguments behind each from NAFTA. opening). version of this hypothesis. F EDERAL R ESERVE B ANK OF S T. LOUIS 34 J ULY /AUGUST 1996 Deliberate Manipulation and Planned of the evidence at that time suggested that Devaluation. the treaty had cost American jobs. So there was considerable pressure to produce evi- “... the devaluation of the peso dence that showed that NAFTA would cre- had been planned for more than a ate jobs in the United States. year and was openly discussed at The Mexican government was not im- the highest levels of the Mexican mune to such pressure. In 1993, passage government. It was also widely of NAFTA by the U.S. Congress was the known in Washington. I discussed main policy concern of the Mexican ad- it in my testimony before the ministration [see Tornell and Esquivel House Committee on Small Busi- (1995)]. In August of that year, President ness in March, 1993—eight Salinas even promised to raise the Mexican months before the North Ameri- minimum wage to alleviate U.S. fears of can Free Trade Agreement was cheap Mexican labor driving down U.S. passed into law.” wages and taking jobs. Critics charge that Ross Perot, Los Angeles Times, because of such political considerations, 6 January 4, 1995. the Mexican government deliberately kept Critics like Ross Perot argue that the the peso overvalued throughout 1993 and Mexican government and the Bank of Mex- 1994 and planned the eventual devalua- ico kept the value of the peso artificially tion well in advance. high to increase political support for the Sensitivity to U.S. Politics. A more rea- treaty in the United States by creating a bi- sonable hypothesis is put forward by Ve- lateral trade surplus with Mexico.