The best way to reduce the deficit is to grow Mexico’s economy

The Limits of a Trade Negotiation

Renegotiating NAFTA is a top priority of the Trump Administration. Related or not, Mr. Trump has also indicated repeatedly that the goal of its trade policy is to reduce large bilateral trade deficits based on its assumption that a bilateral trade deficit is principally caused by unfair trade practices. Mexico’s $63 billion trade surplus (in 2016) with the United States looms large as a factor shaping the Trump NAFTA policy.

Elsewhere on TradeVistas, you can find an Essential on whether the trade deficit is a measure of trade policy effectiveness. (It isn’t.) Also, we have discussed in our Essential, “A Deficit of Good Trade Data,” why the way we measure trade flows, based on final assembly point instead of value-added, has many problems. Just by changing the way we count it, we could shave 75 to 85 percent off our trade deficit with Mexico. Given that, economists generally agree that bilateral surplus/deficit figures are uninteresting and unhelpful to understanding the nature of economic relations with other countries. What’s more, trade barriers have a trivial impact on a nation’s current account balance. The key driver is macroeconomic policy.

What if we take the President at his word?

If the President is intent to reduce the trade deficit with Mexico, what policy should the U.S. pursue?

All three NAFTA parties currently run an overall current account (or, “trade”) deficit. The IMF reported that Mexico’s current account deficit amounted to 2.7 percent of GDP in 2016. That’s only slightly greater than the U.S. current account deficit which was 2.6 percent of U.S. GDP the same year. (Canada’s trade deficit with the world in 2016 was 3.3 percent of GDP.) Considering budgets proposed by the President and the U.S. Congress, it’s safe to conclude that the U.S. is not willing to make the macroeconomic changes necessary to reduce its current account deficit, such as reducing government spending or offering greater incentives for saving over consumption. For this exercise, let’s assume that, like the United States, Mexico is also unlikely to take the macro policy steps needed to change its overall current account position.

Next let’s consider whether changes in trade policy could have an effect on the U.S.-Mexico bilateral deficit. While it is possible that persistent unfair trade practices could have the effect of reducing U.S. exports to Mexico, the NAFTA gave U.S. exporters preferential (i.e., better than Most Favored Nation) access to Mexico’s consumers. The purpose of trade agreements like NAFTA is to address microeconomic factors that affect trade flows, including measures at the border as well as those behind the border. Addressing the “micro” factors generally increases the level of trade and the economic welfare of consumers, but does not have much effect on the balance of trade. In nominal terms, trade flows have more than tripled among the parties since NAFTA was implemented, but trade balances have changed little in recent years.

What about “managing” trade?

The mercantilist approach to addressing a trade deficit would be to impose trade restrictions, to the detriment of people now engaged in voluntary, mutually-beneficial exchanges across borders. At least one senior Trump administration official has proposed this publicly. Wilbur Ross, Secretary of Commerce, was quoted on June 2, 2017 by Inside US Trade as follows:

“The way we think is the easiest…would be to divert to U.S. sources [Mexico is] already buying from abroad, but from a country other than the U.S. For example, some of the agricultural products they buy come from Brazil. Well, they could just as well give us a better market share than we have now. And that’s just one example of many.”

This notion is impossible to square with American values of individual liberty and economic freedom, and would not be tolerated in a domestic context. Unless we are prepared to let our government tell us from whom we may buy or sell (and enforce those instructions with tools of coercion), we should reject the same impulse when applied to foreigners.

Faster economic growth is a better answer

Since we run deficits because we spend more than we save and because trade agreements to address microeconomic factors don’t make dents in trade deficits, one option remains to reduce a bilateral deficit: boost aggregate demand in the trading partner.

The IMF forecasts the U.S. economy will grow by 2.5 percent in 2018. Mexico is forecasted to grow by only 2.0 percent. A serious development effort to boost overall growth in Mexico would raise demand for a wide range of inputs, including goods and services Mexico imports from the United States. The United States now provides around $320 million per year in official development assistance, with the largest share devoted to counter-narcotics and law enforcement efforts. Given that the total GDP of Mexico exceeds $1 trillion per year, the current level of official U.S. assistance would not be enough to make a measurable impact on economic growth. In actuality, NAFTA was the best development program the United States could offer and it benefited our own economy to boot.

Mexico posted first quarter 2017 growth of 2.7 percent, well ahead of forecasts. The United States and Mexico could invest in an economic development plan that would not just reduce a bilateral trade deficit — it would improve living standards for Mexican consumers and help build a stronger middle class. Whether the Trump administration would consider this, growing Mexico’s economy is more likely to achieve what they say they want than are the alternatives.

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