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Number 93-40, November 19, 1993

N,L\FTA and the
Western Economy
The U.s. Congress will vote soon on ratification
of the North American Free Trade Agreement
(NAFTA). The agreement, drawn up during the
Bush Administration and amended by the Clinton Administration in the areas of labor and environmental policies, would significantly reduce
barriers to trade between the United States, Canada, and Mexico.
Considerable opposition has emerged to the
treaty, and ratification remains uncertain. In this
Weekly, we examine how NAFTA is likely to
affect the Twelfth Federal Reserve District. According to our analysis, ratification would benefit
the District by solidifying and expanding on the
gains from trade that already have been seen, especially in California and Arizona. On the other
hand, failure to pass NAFTA could jeopardize
export growth, which has been one of the few
bright spots in California's economy.

Trade and economic growth
Trade, whether between individuals, regions, or
nations, has been a major source of economic
growth and improvement in standards of living.
A region (or an individual or a nation) specializes
in producing goods or services for which it has
a "comparative advantage"; that is, the region
focuses on products it can make better or more
efficiently than other regions can. That region
can then trade those goods or services for other
goods and services produced by regions that
have a comparative advantage in those other
products. By specializing and trading, the range,
quality, and quantity of goods in the economy as
a whole is vastly increased.
Competition is the process by which individuals
and firms sort out their comparative advantage
and identify their specialties. Competition also
encourages innovation, improvements, and gains
in efficiency and productivity. If current producers do not innovate or improve their production processes, others can make advancements
and unde'rcut the current producer's price. Ultimately, the competitive process increases per
capita consumption of goods and services.

Trade and competition require that economic
agents respond to changing conditions. If somebody builds a better mousetrap, the established
mousetrap-maker has two options: It can adapt,
by acquiring new skills and developing new
products and services, or it can go out of business. Thus, firms in a competitive economy have
a strong incentive to innovate, rather than holding steady. Innovation is essential to long-term
improvement in standards of living, but some
firms go through difficult adjustment periods
and some jobs are lost in the process.
Tariffs and other trade restrictions interfere with
the competitive process. Occasionally there are
valid policy reasons for protecting domestic industries. For example, defense considerations can
lead to trade restrictions on certain technologies,
and developing countries may want to nurture
infant industries. However, production that is
sheltered from competition tends to become
less efficient over time.

Where does NAFTA fit in?
NAFTA would reduce trade barriers between the
U.S., Canada, and Mexico. Since the U.S. and
Canada already have entered into a free trade
agreement, NAFTA's primary impact for the u.S.
would be on its trade with Mexico. More open
trade would allow further specialization in the
production of the two countries. Since Mexico
and the u.S. have different levels of capital investment, different labor force characteristics,
and different relative prices, the comparative advantages of each should sort themselves out relatively quickly. With fewer trade restrictions, we
would expect Mexico to specialize in laborintensive production where low labor costs are
very important, while U.S. producers would tend
to specialize in more capital-intensive production that requires more technological sophistication and demands a more highly trained and
productive work force.
With more open trade, both countries should
gain. Increased production in Mexico would
raise incomes there, perhaps significantly, which

would increase demand for u.s. goods. Meanwhile, the u.s. would gain jobs in industries
where workers are paid more because their
workers are highly skilled and productive. However, the tendency for the u.s. to lose low-wage
jobs that require relatively iittle training, which
has been apparent for more than a decade, might
be accelerated somewhat by NAFTA. Some of
these costs might be mitigated if retraining programs are available to displaced U.S. workers.
(For a review of NAFTA's effects on u.s. labor
markets, see Moreno 1993.)
For some time, the Mexican government has
recognized the gains attainable from increased
trading with the U.S. Since 1987, Mexico's average import tariff has been reduced from 23
percent to around 10 percent, and the Salinas
government has made broad moves toward more
liberalized trade. As a result, between 1987 and
1992 the dollar volume of U.S. merchandise exports to Mexico rose 178 percent, a change of
$26 billion. These figures overstate the growth
in trade, because they include the sharp increase
in exports of components to Mexico for assembly
that are returned to the U.S.; still, growth in trade
offinished products has been substantial.

The West's share
Among all states,California ranked second to
Texas in exports to Mexico in 1992, at $6.6 billion, while Arizona ranked third, at $1.8 billion.
Taken together, the seven other Twelfth District
states exported a relatively modest $831 million
in merchandise to Mexico in 1992. Because of
the large volume of exports from Arizona and
California, the analysis will focus on these two
states. In 1992, exports to Mexico equaled 1.0
percent of personal income in California. and
2.8 percent of personal income in Arizona.
California and Arizona benefited disproportionately from the growth in exports to Mexico
during the past several years. Exports of merchandise from California rose 191 percent between 1987 and 1992, or $4.3 billion, providing
one of the few bright spots in an economy hobbled by problems in the real estate and defense
industries. Meanwhile, exports from Arizona rose
186 percent, or $1.2 billion.
In addition to growth in merchandise trade, exports of services have grown sharply. While statelevel data on services exports are not readily

available, at the national level services exports
have risen 144 percent between 1986 and 1991,
suggesting that exports of services from California
and Arizona to Mexico have grown along with
merchandise trade.
Trade theory also suggests that liberalized trade
should be characterized by greater flows of highvalue products from the country whose labor
force is more productive. This pattern also has
emerged in recent years. The largest volumes of
exports from both Arizona and California are
high-value products whose workers earn relatively high wages. For example, electronics and
transportation equipment together accounted for
38 percent of Arizona's 1992 exports to Mexico.
In California, industrial machinery, computers,
and electronic equipment accounted for 39
percent of the 1992 exports to Mexico. For each
of these industries, the average compensation is
higher than the average of compensation across all
of the relevant state's manufacturing industries.

Benefits of passing NAFTA
These gains have come largely because Mexico
has unilaterally reduced its barriers to trade. If
NAFTA passes, the gains that we have already
seen from Mexico's unilateral trade liberalization
would be solidified. Moreover, further reductions
in Mexican tariffs would result, since the average
level of tariffs is still more than twice as high in
Mexico as it is in the U.S. Tariffs on computers,
which are now much higher than average, are especially likely to fall. The impact on exports
from California and Arizona would definitely be
Many have expressed concerns that the passage
of NAFTA could induce u.S. manufacturing firms
to locate in Mexico to take advantage of wage
rates that are only a quarter of those paid to u.s.
manufacturing workers. Indeed, as demonstrated
by rapid growth in the past decade in the maquiladora program, many labor-intensive manufacturing firms have moved operations across the
However, wage rates are only one part of the
pictu(e. Research at the Federal Reserve Bank of
Dallas (1993) finds that productivity is nearly five
times higher for manufacturing workers in the
U.S. than in Mexico. Thus, adjusting for productivity differences, wages per unit of output are
actually lower in the U.S. because of the access

to higher skilled workers, efficient transportation
and communication networks, capital equipment, and other inputs.
In nearly all estimates of NAFTA's effects, the
results show a modest net gain of jobs in the u.s.
Moreover, the industries in which u.S. producers
have a comparative advantage over Mexican producers tend to be those in which education, training, and skill levels make u.s. workers especially
productive. Electronic equipment, computers,
and industrial machinery, which are particularly
important sources of exports from Arizona and
California to Mexico, fit this description. The industries that are more likely to lose jobs are those
that do not require the education or productivity
that would justify paying higher U.S. wages.

Moreover, increased attention to environmental
quality typically rises with a nation's standard of
living. Consequently, to the extent that growing
trade with Mexico boosts Mexico's standard of
living, the attention to reducing pollution there is
likely to rise over time. This increased interest in
pollution control could even create an additional
market for u.s. products, since the u.s. is a
leader in environmental technologies. This potential market is particularly important to the

states of the Twelfth District, where some of
the leading environmental technology firms are
located. According to the California Governor's
Office of Planning and Research, California alone
accounts for 7.5 percent of the world's revenues
to environmental industries.

Thus, the jobs that are vulnerable to being lost to
Mexico are the same jobs that have been moving
overseas (to Asia as well as to Mexico) for the
past decade. That is, increasingly open trade with
Mexico has caused and will continue to cause
some movement of low-wage jobs out of the u.s.
However, it is worth noting that the jobs that are
threatened by NAFTA are in industries in which
U.s. manufacturers already have had trouble
competing against many low-wage countries.
Thus, even without NAFTA, many of those jobs
will be lost to other countries in Asia or Latin
An additional way in which NAFTA would be
expected to affect labor markets is through immigration. At present, there is a great deal of
concern, especially in California, about the adjustment costs associated with absorbing large
numbers of immigrants. Many of those immigrants are from Mexico; and most are searching
for better jobs than they currently can find in
Mexico. Over time, however, the passage of
NAFTA would likely result in substantial improvements to the standard of living in Mexico
relative to the present situation, and in doing so,
ultimately would reduce the incentive to migrate
to the u.s.
Opponents of NAFTA also have raised concerns
about environmental standards. Firms, they argue, will cross into Mexico to use highly polluting processes and then market the product in the
u.s. The side agreements address this issue by
creating mechanisms to increase environmental
quality in Mexico and by making it more difficult
to cross the border and pollute.

California and Arizona have benefited greatly
from recent growth in trade with Mexicogrowth that has been associated with Mexico's
unilateral reductions in trade restrictions. NAFTA
would solidify many of these gains and would
stimulate further gains. Some job dislocations
can be expected, particularly in low-wage industries, which suggests a need for domestic policies for worker retraining. Overall, however,
there is likely to be a net gain in the number of
jobs, and the job gains should come in highwage industries in which u.s workers are especially productive. More open trade, by exposing
industries to increased competition, forces domestic industries to keep innovating. The result,
therefore, is continuing improvement in the
standard of living in the u.s. and some much
needed stimulus to California's beleaguered

Ronald H. Schmidt
Senior Economist

Carolyn Sherwood-Call

California Governor's Office of Planning and Research.
1993. The North American Free Trade Agreement: Implications for California. Sacramento.
Federal Reserve Bank of Dallas. 1993. The Southwest
Economy (November/December).
Moreno,Ramon. 1993. "NAFTA and
Weekly Letter 93-24 Oune 24).

u.s. Jobs:' FRBSF

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author•.•. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.


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Index to Recent Issues of FRBSF Weekly Letter



Is Banking on the Brink? Another Look
European Exchange Rate Credibility before the Fall
Computers and Productivity
VAJestern Metal Mining
Federal Reserve Independence and the Accord of 1951
China on the Fast Track
Interdependence: U.S. and Japanese Real Interest Rates
NAFTA and U.S. jobs
japan's Keiretsu and Korea's Chaebol

Interest Rate Risk at U.S. Commercial Banks
Whither California?
Economic Impacts of Military Base Closings and Realignments
Bank Lending and the Transmission of Monetary Policy
Summer Special Edition: Touring the West
The Federal Budget Deficit, Saving and Investment, and Growth
Adequate's not Good Enough
Have Recessions Become Shorter?
California's Neighbors
Inflation, Interest Rates and Seasonality
Difficult Times for japanese Agencies and Branches
Regional Comparative Advantage
Real Interest Rates
A Pacific Economic Bloc: Is There Such an Animal?


The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.