a joint initiative of ludwig-maximilians-universität …timeline that ended in 2009. tariffs and...

84
Forum W INTER 2010 Trends Focus NAFTA Carol Wise Christian Deblock and Michèle Rioux Robert A. Blecker and Gerardo Esquivel Dominick Salvatore Philip Martin Meera Fickling Specials TURBULENT W ATERS IN THE EMU: TRANSLATION FROM WIRTSCHAFTSWOCHE GREENSPAN, DODD-FRANK AND STOCHASTIC OPTIMAL CONTROL ESTIMATION OF PRODUCTION COSTS FOR ENERGY RESOURCES REPEC – A PLATFORM FOR MEASURING OUTPUT IN ECONOMICS Karl Otto Pöhl Jerome L. Stein Hans-Dieter Karl Christian Seiler and Klaus Wohlrabe STATISTICS UPDATE A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research VOLUME 11, NO. 4

Upload: others

Post on 07-Jul-2020

0 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

Forum W I N T E R

2010

Trends

Focus

NAFTA Carol Wise

Christian Deblock andMichèle Rioux

Robert A. Blecker andGerardo Esquivel

Dominick Salvatore

Philip Martin

Meera Fickling

Specials

TURBULENT WATERS IN THE EMU:TRANSLATION FROM

WIRTSCHAFTSWOCHE

GREENSPAN, DODD-FRANK AND

STOCHASTIC OPTIMAL CONTROL

ESTIMATION OF PRODUCTION COSTS

FOR ENERGY RESOURCES

REPEC – A PLATFORM FOR

MEASURING OUTPUT IN ECONOMICS

Karl Otto Pöhl

Jerome L. Stein

Hans-Dieter Karl

Christian Seiler andKlaus Wohlrabe

STATISTICS UPDATE

A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research

VOLUME 11, NO. 4

Page 2: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum ISSN 1615-245X (print version)ISSN 2190-717X (electronic version)

A quarterly journal on European economic issuesPublisher and distributor: Ifo Institute for Economic Research e.V.Poschingerstr. 5, D-81679 Munich, GermanyTelephone ++49 89 9224-0, Telefax ++49 89 9224-98 53 69, e-mail [email protected] subscription rate: €50.00Single subscription rate: €15.00Shipping not includedEditors: John Whalley ([email protected]) and Chang Woon Nam ([email protected])Indexed in EconLitReproduction permitted only if source is stated and copy is sent to the Ifo Institute

www.cesifo-group.de

Page 3: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

Volume 11, Number 4 Winter 2010_____________________________________________________________________________________

NAFTA

The North American Free Trade Agreement: A RequiemCarol Wise 3

NAFTA – A Model Running Out of Breath?Christian Deblock and Michèle Rioux 9

NAFTA, Trade and DevelopmentRobert A. Blecker and Gerardo Esquivel 17

Measuring the Economic Effects of NAFTA on MexicoDominick Salvatore 31

NAFTA and Mexico-US Migration: What Lessons, What Next?Philip Martin 38

North America’s Uphill Battle on Climate Change and Its Implications for the North American Trading SystemMeera Fickling 45

Turbulent Waters in the EMU: Translation from WirtschaftsWocheKarl Otto Pöhl 52

Greenspan, Dodd-Frank and Stochastic Optimal ControlJerome L. Stein 55

Estimation of Production Costs for Energy ResourcesHans-Dieter Karl 63

RePEc – An Independent Platform for Measuring Output in EconomicsChristian Seiler and Klaus Wohlrabe 72

Statistics Update 78

Focus

Trends

Specials

Forum

Page 4: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year
Page 5: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/20103

Focus

THE NORTH AMERICAN

FREE TRADE AGREEMENT: A REQUIEM

CAROL WISE*

Despite the emphasis that then-presidential candidateBarack Obama placed on the need to renegotiate theNorth American Free Trade Agreement (NAFTA)during his 2008 US presidential campaign, thispromise has thus far come to naught. Once elected,President Obama’s first foreign visit was to Mexico toconfer with President Felipe Calderón. During thisdiplomatic foray Obama assured Calderón that theUnited States mainly intended to upgrade those partsof NAFTA that were of most concern to US voters,namely, labor standards and environmental protec-tion. Yet, when the ‘Three Amigos’ met for their firstNAFTA summit in 2009, the agenda discussed byObama, Calderón, and Canadian Prime MinisterStephen Harper was dominated by the problem ofundocumented migration of Mexican workers intothe United States and Canada and by the explosion ofdrug trafficking and cartel-related violence along theUS-Mexico border.

As palpable as the domestic debate over the need forNAFTA reform may have seemed at the time of the2008 US presidential election, the fact is that NAFTAis more or less beside the point at this political eco-nomic juncture. This is because 99 percent of all tar-iffs on those goods and services covered by NAFTAhave basically been eliminated, and because politi-cians and policy makers in all three of the membercountries have failed to institutionalize and updatethe agreement in ways that address problems that aremultiplier effects of NAFTA itself. At the top of thislist – apart from the easy flow of drugs and undocu-mented migrants across the border – would be thefailure to promote export competitiveness and to fos-ter the development of NAFTA as a regional projectproper. With NAFTA now fully implemented, the

inability of political leaders in North America to ren-

ovate and expand on the accord has meant its eclipse

by more compelling global forces.

The most remarkable force is the rapidity with which

China has gained a foothold in sectors once consid-

ered ‘North American’, such as computer peripherals,

sound and television equipment, telecoms, electrical

machinery, equipment and parts. Since China’s 2001

entry into the World Trade Organization (WTO) its

exports have steadily surpassed those of Mexico and

Canada in any number of US market niches. What’s

more, US exports, mainly in auto parts and produc-

tion, are quietly being displaced by Chinese investors

in Mexico’s northern export processing, or maquila,

zones. Canada and Mexico remain the most impor-

tant trading partners of the United States overall, and

together represent the largest supply of US energy

imports; however, when it comes to remedies for

today’s economic pain, China, it seems, should be the

main departure point for any debate over the current

sources of job dislocation and associated economic

stress in the United States and larger North American

market.

Economic policy and public discourse across North

America has yet to register the full implications of

China’s rapid ascendance in regional markets. Even

though the prospect of the ‘China threat’ has spawned

a whole cottage industry of academic and popular

books in the West, apart from launching a series of

elite diplomatic dialogues and pressuring the Chinese

to revalue their currency, Washington, Ottawa and

Mexico City have been slow to react.

Nevertheless, although competition from China may

be the most obvious factor in accounting for height-

ened job insecurity in both the United States and

Mexico, NAFTA still bears its own share of the pub-

lic’s wrath. Despite NAFTA’s considerable break-

throughs, the North American project has been

stymied by continued political gridlock over trade

policy in the United States, as well as some bitter dis-

appointments over expectations versus actual out-

comes with regard to labor and the environment.

NAFTA may still carry symbolic weight for the US

NAFTA

* University of Southern California, Los Angeles.

Page 6: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

electorate, but at this point it seems safe to say that the

agreement has been steadily relegated to history’s

junk heap.

NAFTA: from glitz to gloom

It is now twenty years since former Mexican trade

minister Jaime Serra Puche and US Trade

Representative Carla Hills sat down at the annual

Davos Forum to explore the possibilities for negotiat-

ing what would later become the North American

Free Trade Agreement. The Uruguay Round was in

limbo at the time and the decision of the US to nego-

tiate a bilateral free trade agreement (FTA) that

included a developing country was unprecedented.

But this is just one way in which NAFTA broke new

ground.

A second benchmark for NAFTA was Mexico’s will-

ingness to forgo any special or different treatment

related to its developing country status at the NAFTA

negotiating table. It is difficult to exaggerate the extent

to which this stance represented a complete U-turn in

Mexico’s approach to foreign economic policy. The

decision marked the advent of a new generation of

more technocratic policy makers within the upper

echelons of the state bureaucracy and the eagerness of

this market-oriented cohort to lock in an entirely new

set of policies based on liberalization, privatization,

and deregulation.

This paved the way for a final agreement that went

well beyond what had been accomplished to date

within the Uruguay Round. On this count, NAFTA’s

key innovations were the protection of intellectual

property rights (IPRs), the liberalization of invest-

ment and trade in services, and the creation of mech-

anisms to resolve investment disputes based on bind-

ing international arbitration. For the first time, ‘old’

issues on the multilateral trade agenda (market access

for agricultural and industrial goods) were combined

in one agreement with the kinds of ‘new’ issues (ser-

vices, investment and IPRs) that the OECD countries

had been pushing for at least since the Tokyo Round

of the General Agreement on Tariffs and Trade

(GATT).

The fourth breakthrough was the negotiation and

attachment of labor and environmental side accords

to the NAFTA agreement, as the prospect of

Mexico’s entry into an FTA with the United States

and Canada had invoked valid worries about environ-

mental dumping and the abuse of labor rights in theselatter countries. Historical in their own right, theselabor and environmental agreements were offered upby the Clinton administration as side payments togarner congressional votes for NAFTA and tocounter the political blowback on the domestic frontthat had arisen with regard to the steep asymmetriesbetween Mexico and the United States.

Along with the side agreements on labor standardsand environmental protection, the NAFTA accordpromoted the free flow of goods, investment, and ser-vices within the North American bloc over a 15-yeartimeline that ended in 2009. Tariffs and non-tariffbarriers were eliminated on 65 percent of NorthAmerican goods by the 5-year point; tariff reductionson automobiles occurred over a 10-year period, withthe rules-of-origin stipulation that such vehicles mustmeet a 62.5 percent local-content requirement inorder to qualify.1 In the agricultural sector, sensitiveproducts were allotted a 15-year liberalization sched-ule that ended in 2009.

In the end, negotiating tensions were such that sugarand dairy products were excluded altogether in tradebetween Canada and Mexico. This is just one way inwhich NAFTA still fell short of its mandate to liber-alize substantially all trade between the three part-ners. First, administered protection persisted in thesetting of hefty percentages for local content underNAFTA’s rules of origin in such sectors as autos,high-tech products and textiles and apparel. Second,little progress was made toward the elimination ofantidumping practices and countervailing duties.Despite the ability of special interests to secure theseprotectionist concessions, hindsight suggests thatNAFTA has been a liberalizing force overall, as eachparticipant was clearly looking to reduce transactioncosts while simultaneously increasing the benefits ofcooperation.

Canada and Mexico saw an opportunity to secureaccess to the US market and establish clearly definedrules and procedures for resolving trade and invest-ment disputes. The United States, while also con-cerned with promoting and rationalizing economicties within the North American bloc, primarily soughtto bolster the rules and norms that constituted theinternational trade regime codified within the GATT.

CESifo Forum 4/2010 4

Focus

1 In order to qualify for NAFTA’s preferences, goods have to: (1) beproduced entirely within the NAFTA bloc; (2) incorporate onlythose non-NAFTA materials that are sufficiently processed in NorthAmerica to qualify for a tariff reclassification; and (3) satisfy a min-imum-content rule.

Page 7: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/20105

Focus

Although pragmatic in the sense that all three parties

sought to strengthen and institutionalize respective

political-economic ties that had long been in place but

had heretofore been managed in an ad hoc manner,

hindsight shows that NAFTA also unexpectedly

unleashed its own share of animal spirits in North

America.

From the launching of the negotiations in September

1991 to the ratification vote in the US House of

Representatives in November 1993, the tone of the

NAFTA debate was counter-intuitive. Economic inte-

gration theory suggests that both the United States

and Canada, as larger, wealthier and more open G8

economies, should anticipate that marginal adjust-

ments would occur. In turn, Mexico, as the smaller,

poorer and more closed economy, should expect to

undergo a more costly adjustment in the short term,

but to realize considerable dynamic gains in the medi-

um to long term.

From this theory it should follow that the debate over

whether to pursue an FTA would be more heated in

Mexico, the country that had the most at stake.

Conversely, given that the United States and Canada

had much less on the line, one would expect a fairly

tame discussion about whether to negotiate an FTA

that included Mexico. Paradoxically, the opposite sce-

nario emerged.

In Mexico, the administration of Carlos Salinas

(1988–1994), which oversaw the NAFTA negotia-

tions, was able to quell open debate over NAFTA by

drawing on the authoritarian clout of its ruling

Revolutionary Institutional Party (PRI) to reinforce

informational asymmetries and marginalize dis-

senters. In Canada and the United States, the

NAFTA debate literally exploded. In the United

States, in particular, a full-scale national controversy

ensued, a main upshot being the emergence of a blue-

green coalition of grassroots labor and environmen-

tal activists that managed to insert non-trade issues

onto the US trade policy-making agenda like never

before.

First was a realistic reaction to the miserable work-

ing conditions and badly polluted maquila factory

sites that lined the US-Mexico border. If NAFTA

signified the free flow of goods, services, and capital

between all three countries, what was to stop the

flow northward of environmental pollution and

sub-standard working conditions? To the chagrin of

free trade purists like Jagdish Bhagwati,2 it was this

coalition that compelled the senior Bush adminis-tration to expend political capital on border cleanupand the enforcement of much higher environmentalstandards. With the election of President BillClinton in 1992, the formal negotiation of labor andenvironmental side agreements to accompanyNAFTA was offered as a quid pro quo for the blue-green endorsement of the 1993 NAFTA-implement-ing legislation.

The second reaction was largely symbolic, wherebyNAFTA came to embody all that was cumulativelywrong with the US political economy at the outset ofthe 1990s. What had started out as an issue-orientedblue-green coalition in 1991 blossomed into a full-blown anti-NAFTA movement that included every-one from job-seeking college graduates to downsizedbusiness executives, laid-off factory workers to teach-ers’ unions. Regardless of the actual effect thatNAFTA would have on any of these constituents,they were united in the perception that they had some-how been excluded from the prosperity that surround-ed them in the late twentieth century, and they wereunderstandably angry about it.

NAFTA’s self-appointed ‘losers’ have thus kept theopposition to further trade pacts alive, as witnessed inthe paper thin margins by which subsequent US bilat-eral FTAs have been ratified by the US Congress,including the 2006 US-Central America FTA. Butbeyond this phenomenon of NAFTA coming to sym-bolize a general sense of downward mobility in theUnited States, it is the tenacity of the blue-green coali-tion and its effect on congressional deliberations thatperhaps best accounts for the testiness of US tradepolicy since the launching of NAFTA.

Although this coalition won the battle in securing theattachment of labor and environmental side agree-ments to NAFTA, the lackluster enforcement ofthose agreements has further prolonged the trade pol-icy war on the domestic side. During the entire Bushadministration in the 2000s, for example, just twolabor complaints against Mexico were accepted forreview, whereas on the environmental side just sevencases involving Mexico have been resolved over thelife time of the agreement. Thus, much of the fighthas centered on correcting the institutional weakness-es in those earlier agreements, namely, the obligationof each country to enforce its own existing nationallaws but with little regard for strengthening and har-

2 See Bhagwati (2008).

Page 8: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

monizing North American labor and environmentalstandards overall.

The blue-green opposition has continued its demandsfor more binding commitments in enforcing labor andenvironmental standards. Hence, the US insistence onincorporating labor and environmental stipulationsinto the pending Doha agreement, as well as the sub-sequent FTAs signed in the 2000s. Even seeminglyeasy US bilateral talks with countries that are other-wise ready and willing to constructively adhere to thefull menu of blue-green demands (South Korea,Panama, Colombia) have proved to be quite cumber-some.

NAFTA’s uneven returns

NAFTA’s critics have arguably done a better job ofadvertising its failures than its proponents have donein touting the concrete gains that have underpinnedNorth American integration since the early 1990s. Atleast at the aggregate level, it would be difficult topaint NAFTA as anything but a success. This is espe-cially so when NAFTA is judged according to its owngoals: the creation of a free trade area in which allthree partners have pursued an economic growthstrategy via the liberalization of goods, capital, andservices amongst themselves.

Total NAFTA trade now accounts for some 30 per-cent of all US trade,3 and the number of jobs gainedin the US economy since NAFTA’s implementation in1994 more than compensates for those jobs lost – evenwhen considering the massive job losses that haveoccurred in the wake of the 2007–2009 US financialcrisis. US trade in goods and services with Canadaand Mexico tripled – from 341 billion US dollars in1993 to more than 1 trillion US dollars in 2007 – andinward foreign direct investment quintupled amongthe three countries and increased tenfold in Mexicobetween 1990 and 2005 (Pastor 2008). In terms ofgross product, the NAFTA zone has now surpassedthe European Union (EU); however, the impacts ofregional integration in North America have beenquite uneven.

Again, when viewed from the dictates of economicintegration theory, it was expected that NAFTAwould benefit all three countries, but especiallyMexico, through the deepening of already strong ties

in cross-border production and intra-industry trade.

First, the elimination of barriers at the border would

promote scale economies related to greater specializa-

tion, increased technological capabilities, and more

rapid and efficient deployment of those factors for

which Mexico has a comparative advantage (natural

resources and comparatively cheap labor).

Second, it was argued that the blending of Mexico’s

abundant factors with the capital, technology, and

know-how that Canada and the United States

brought to the table would trigger a dynamic pattern

of income convergence among the three members.

According to this largely neoclassical trade narrative,

Mexico would readily advance up the industrial and

technological learning curve, substantially increase its

per capita income, and more authentically approxi-

mate the economic indicators of its fellow OECD

members.

The data show that NAFTA has delivered rather

erratically on these expectations. At the macroeco-

nomic level, Canada and Mexico have clearly con-

verged toward the more highly developed US stan-

dard in terms of aggregate growth, interest rates,

exchange rate stability and the lowering of inflation to

under five percent annually. But the microeconomic

data tell a different story, which highlights the need

for sound domestic policy reforms to complement and

maximize on the opportunities intrinsic to a regional

integration scheme.

After rebounding from the disastrous 1994 peso crisis,

the growth of per capita gross domestic product

(GDP) in Mexico has hit a virtual standstill in the

2000s and is still 6.3 times lower than that of the

United States. Even Canada, despite its advantage as

a G8 country, has lagged in this regard. Although

Canadian income distribution is the most equitable in

North America, Canada’s per capita income remains

about 20 percent lower than that of the United States

and its productivity and investment ratios are similar-

ly trailing.

While the roots of microeconomic under-perfor-

mance appear to lie somewhere in the gulf between

neoclassical trade theory – which assumes a state of

perfect competition and constant returns to scale

under NAFTA – and the concrete empirical obstacles

that underpinned its launching back in the early

1990s, the persistent divergence between the United

States and its NAFTA partners can also be chalked

up to the nature of political institutions and policy

CESifo Forum 4/2010 6

Focus

3 TradeStats Express, International Trade Administration, USDepartment of Commerce.

Page 9: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/20107

Focus

making in these countries. In short, both Canada and

Mexico, albeit in greatly varying degrees, are still in

need of more proactive competition policies that spur

rather than deter investments, increase ties between

research and development (R&D), universities and

private initiative, and promote the application of

advanced technology to the extraction of natural

resources and the production of goods.

NAFTA’s potential here is limited, as it has delivered

its punch in terms of the role that enhanced levels of

trade and investment can play in catalyzing further

microeconomic change for both Canada and Mexico.

Because of the minimalist institutional framework

that all three members agreed to at the outset,

NAFTA has basically been frozen in place and is sore-

ly out of date when it comes to tackling today’s micro-

economic challenges.

The twilight of North American integration

The importance of Canada and Mexico as US trade

and investment partners is indisputable, and the

impressive growth of North American gross product

is testimony to the depth of these ties. At this point,

however, NAFTA’s operational tendencies are still

more akin to two bilateral deals that have basically

been cobbled together, meaning that the whole is no

greater that the sum of its parts. Whereas the very cre-

ation of NAFTA is testimony to the possibilities of

trilateral coordination based on the national interests

of each trade partner, all three countries adamantly

resisted the option of strengthening this cooperation

via the creation of European Union (EU)-style supra-

national institutions.

Canada and Mexico opposed the institutional for-

malization of NAFTA on the grounds that they

would be pushed around and further disempowered

by the United States if North America were to take

the supranational institutional route. The United

States reacted in its typical Anglo-Saxon fashion,

pejoratively equating the creation of supranational

institutions with the proliferation of the ‘Brussels

bureaucracy’ in North America. This insistence

that NAFTA remain a free trade area in the absence

of sound institutional moorings has thus stunted its

evolution into a more compelling regional project.

Case in point: the growth in total NAFTA trade in

the 2000s has been about 3 percent, versus the

9.8 percent growth rate registered in 1994–2000

(Pastor 2008).

In light of this impasse, it seems safe to say that the

authentic revival of NAFTA as a regional project

would require that the United States, as the hegemon-

ic member and industrial anchor, step forward with

the necessary leadership and provision of public

goods. Yet, the most visible US commitment in the

Bush junior era was the construction of a double-lay-

ered wall and hundreds of miles of vehicle barriers

along the 1,933-mile US-Mexico border meant to halt

the northward flow of undocumented workers.

Mandated by the Secure Fence Act of 2006 in the

wake of failed efforts within the US Congress to reach

bipartisan agreement on any number of sticking

points in the proposed immigration legislation, the

US Department of Homeland Security expects to

complete this project by 2011 at a cost of 7.6 billion

US dollars. Rather than investing in badly needed

improvements in the highway infrastructure that links

the three countries, this hefty US financial commit-

ment to construct further border barriers has under-

standably enraged its NAFTA partners.

A final wedge is China, now a major trade and invest-

ment presence throughout the Western Hemisphere.

Whereas China’s trade relationship with South

America is based on more traditional patterns of

comparative advantage – China’s export of lower-end

industrial goods and its import of primary products

from Argentina, Brazil, Chile and Peru, in particular

– the China-NAFTA relationship is one of export

similarity and fierce competition for manufacturing

market share, especially with regard to Mexico and

the United States (Devlin 2008).

Between 2002 and 2008, Mexico’s share of the US

import market slipped by 11 percent, from 11.6 to

10.3 percent, while China’s share rose by 50 percent,

from 10.8 percent to 16.2 percent (Watkins 2009).

Given that nearly all of Mexico’s manufactured exports

to the United States are goods produced by companies

that operate under the maquila (two-thirds of manu-

factured exports) or Pitex (one-third of manufactured

exports) programs, i.e. programs that were specifically

designed to deepen US-Mexican integration in these

sectors, it is incumbent upon both sides in this partner-

ship to work jointly to combat these intense competi-

tive challenges from China. Remarkably, US and

Mexican leaders in the public and private sector have

been completely passive on this count.

Along with China’s outpacing of all other developing

countries in its growth of manufactured exports from

2000–2006, it is now increasing its competitiveness in

Page 10: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

high technology exports at an even greater speed than

in manufacturing as a whole (Gallagher and

Porzecanski 2010). Although Mexico is the only Latin

American country to rank amongst the top twenty

developing countries in terms of the technological

content of its manufactured exports, Kevin Gallagher

and others report that as of 2006, 82 percent of

Mexican exports in this category were under some

degree of competitive threat from China (Gallagher

and Porzecanski 2010).

The irony in Mexico’s case is that the stated purpose

of the country’s 1994 entry into NAFTA was precise-

ly to advance steadily up the industrial learning curve

and to situate domestic producers more securely on

the technological frontier. What went wrong? Prior to

entering NAFTA, trade and investment were liberal-

ized and longstanding industrial policies were dis-

mantled. Under NAFTA, the innovation process,

including technology transfer and R&D, was relegat-

ed to foreign direct investment (FDI) in Mexico’s

assembly plants, and it was envisioned that innova-

tion would result from the dynamic spillovers and

multiplier effects of heightened trade and investment

flows. However, sixteen years later, expenditures on

R&D have actually declined since 1994, and under

the prevailing laissez-faire regime the country’s

Information Technology (IT) sector and firms have

been decimated.

With US policy makers fixated on the completion of a

highly symbolic wall along the Mexican border, and

US public opinion holding on to its longstanding

NAFTA grudge, Chinese investors are also quietly

staking out their claims in the Mexican market. The

overriding goal is to establish manufacturing opera-

tions in Mexico based on integrated global production

chains, with an eye toward exporting to the US market.

For example, while still an incipient trend, the Chinese

computer company Lenovo is establishing supply

facilities in the northern Mexican state of Chihuahua,

the Golden Dragon firm is constructing a plant to

produce copper tubes in the state of Coahuila and, in

the Mexican state of Hidalgo, China’s Giant Engine

Company has invested 50 million US dollars to

acquire an auto assembly plant (Ellis 2009). Through

joint partnerships with companies such as Mexico’s

Grupo Elektra, a major distributor and financier of

infrastructure, Chinese automakers like Zhongxing,

the First Automobile Works, and others have set their

sights on jointly producing some 1.6 million cars per

year in Mexico by 2012.

Thus, the United States could soon be facing theworst-case scenario of all with regard to its mam-moth commercial deficit: the displacement of USsuppliers by Chinese firms in Mexico’s maquila

assembly plants – a trend that is now underway – andChina’s ability to offset Mexico’s higher labor andproduction costs by meeting NAFTA’s regional con-tent requirements and thereby gaining duty-freeaccess to the US market.

Needless to say, this is a far cry from what NAFTA’sarchitects originally had in mind. Unhappily, thedaunting domestic and regional repercussions of the2007–2009 financial meltdown in the United States,combined with President Obama’s considerable lossesin the US 2010 mid-term elections, do not bode wellfor policy innovation vis-a-vis NAFTA. As Canadalooks once again to the EU for answers and Mexicoretreats into a survival-oriented mode, it seems safe tosay that North America has officially entered thepost-NAFTA era.

References

Bhagwati, J. (2008), Termites in the Trading System, New York:Oxford University Press.

Devlin, R. (2008), “China’s Economic Rise”, in: Roett, R. and G. Paz(eds.), China’s Expansion into the Western Hemisphere, WashingtonDC: Brookings Institution, 111–147.

Ellis, E. (2009), China in Latin America: The Whats and Wherefores,Boulder: Lynne Rienner.

Gallagher, K. and R. Porzecanski (2010), The Dragon in the Room,Palo Alto, CA: Stanford University Press.

Pastor, R. (2008), The Future of North America, Foreign Affairs 87,84–98.

Watkins, R. (2009), The China Challenge to Manufacturing inMexico, Paper presented at Global Perspectives Conference: Focuson China, University of Arizona, April.

CESifo Forum 4/2010 8

Focus

Page 11: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/20109

Focus

NAFTA – A MODEL

RUNNING OUT OF BREATH?

CHRISTIAN DEBLOCK AND

MICHÈLE RIOUX*

‘Marriage of convenience’ or ‘default choice’(Weintraub 1990; Brunelle and Deblock 1989)? In anycase, turning to the United States and embracing freetrade, Canada and Mexico abandoned economicnationalism that reached its limits in the 1980s andmade a bet that securing a broadened, safe and prefer-ential access to their main market, they would takeadvantage of North American integration. First, itwould stimulate their stalled economies and restoregrowth on new foundations. It would allow them touse the US market as a springboard for successful andcompetitive insertion into the global economy and itwould attract foreign investments looking for a gate-way to the US market. Other arguments were alsoimportant. In the case of Canada, for example, fear oflosing the advantages gained from the free trade agree-ment (FTA) signed with the United States in 1987,and, in the case of Mexico, NAFTA was an opportu-nity to lock in economic reforms. The United Stateshad more ambitious goals. The first was to establish alarge open market to enable US businesses to takeadvantage of deep integration de jure with their firstand third largest trading partners; the second was tobuild on this agreement and accelerate multilateral ne-gotiations and other negotiations;the third was to meet the chal-lenges of relentless globalization,the revival of European integra-tion and the rise of Asia as aneconomic power. North Americawas to become also a model thatwould pave the way for the cre-ation of other regional groupings(APEC, FTAA, transatlanticFTA and AGOA) (Deblock andTurcotte 2003).

The debate on NAFTA had political, legal, econom-ic, cultural and social dimensions. In Canada andMexico, it was seen as a direct threat to national sov-ereignty, social programs and developmental policies.In the United States fear of deindustrialization, or bymass relocations to Mexico were dangers shapingpublic opinion and debates. Yet, most pessimistic sce-narios did not materialize and the US economy expe-rienced strong growth throughout the 1990s, stimu-lated by globalization, inflows of foreign investmentsand development of new technologies, and this hadpositive impacts on growth in Canada and Mexico.NAFTA, nonetheless, continues to spark debates fordifferent reasons. First, it has lost much of its appealas a model of regionalism, as other models now com-pete with it, and second, NAFTA has become far lessinteresting to investors, and trade inside NAFTA aredwindling. Third, increasing pressure of internation-al competition is accompanied in Canada andMexico with another economic concern: sluggishproductivity. We will examine these three points inthe following pages, and conclude by asking a mostimportant question: “is NAFTA running out ofbreath as a model of regionalism, and if so, whatshould be done about it?”

NAFTA as a model

NAFTA is associated with the emergence of a modelof ‘new regionalism’, referred to as ‘open’ regional-ism as opposed to the previous models of ‘closed’.

* CEIM (Centre d’études sur l’intégra-tion et la mondialisation) and Universitédu Québec à Montréal (UQAM).

Table 1

Growth of real GDP and GDP per capita in Canada, Mexico

and the United States

Average annual GDP growth rate (%)Period

Canada Mexico United States

1980–89

1990–99

2000–09

3.0

2.4

2.1

2.4

3.4

1.9

3.1

3.2

1.8

Average annual growth rate of GDP per capita (%)Period

Canada Mexico United States

1980–89

1990–99

2000–09

1.9

1.3

1.1

– 0.5

1.7

0.9

2.5

1.9

0.8

Source: IMF World Economic Outlook Database.

Page 12: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

The formula is well conceived but does not accurate-ly reflect the reality as any RTA (Regional TradeAgreement) is preferential and exclusive. The differ-ence distinguishing new and old ones is, on the onehand, their institutional characteristics: generally,they are trade agreements aiming to liberalize trade,and they are mostly bilateral and they are character-ized by a contractual approach. On the other hand,they are directed toward international markets, i.e.towards the promotion of trade in the broadest sense.They are also negative, yet in-depth integrationagreements. ‘Negative’ in that they aim to removebarriers to trade and competition. And ‘deep’because they also tend to harmonize rules and poli-cies in different areas of trade and investment with-out involving the elaboration of common policies(Lawrence 1996).1

NAFTA is a very comprehensive agreement coveringnot just trade in goods (including agriculture and ser-vices) but also investment, telecommunications, gov-ernment procurement contracting, intellectual prop-erty, standards and the movement of business people.In other words, it seeks as much to open up marketsas to establish common market rules, while avoidingthe negotiation of common policies. NAFTA resem-bles the European model but it does not go as far asfor example, setting a common competition policy.Where NAFTA radically differs from the Europeanmodel because it is essentially a ‘contractual’ agree-ment aiming at the sole objectives (Preamble and Art.102) of establishing a free trade zone subject to a sys-tem of fair competition, resolving disputes effectivelyand promoting trilateral cooperation in various areasrelated to the agreement.

NAFTA binds parties to respect the principle of equaltreatment (national treatment and most favorednation clause, MFN), with exceptions and otherclauses clearly identified. Also, as with any contract,parties must comply with the commitments made andmust submit, in cases of dispute, to procedures ofarbitrage and, where applicable, to a binding disputesettlement system. Its institutions are declined on fourlevels: ministerial (a commission on free trade andcommissions in the areas of environment and laborcooperation), administrative (coordinators and threesecretariats), legal (dispute settlement) and technical

(groups and working committees). The agreement isintended only to create an institutional and legal envi-ronment conducive to free movement of goods and

services, capital and business people. One importantaspect to mention is that, contrary to the ongoingintegration process in Europe, the agreement is notupgradeable. Some proposals were made to improvethe agreement, notably by President Zedillo who pro-posed to establish a regional development fund, andto transform it into a customs union or common cur-rency union, but these proposals were not pursuedand neither seriously considered.2

NAFTA might not have lead to as much debate if theUnited States had not sought to use it for purposes.The United States’ objectives, however, went farbeyond the North American framework. In the firstplace, the agreement was meant to create precedentsand to serve as leverage to advance multilateral nego-tiations in areas as contentious as investment andintellectual property rights. Firstly, for example,Chapter 11 on Investment (Part V) served as a modelfor negotiations, which ultimately failed, of a multi-lateral agreement on investment (MAI) (Gagné 2001).Secondly, Mexico was to serve as an example, demon-strating that trade liberalization coupled with contin-ued reforms could lead to vigorous growth and devel-opment creating jobs and wealth, and this, in return,would contribute to reinforce democracy, greaterrespect for individual rights, greater economic securi-ty and control of migration flows. And thirdly, astrong signal had to be sent to all countries willing tolaunch bilateral negotiations with the United States,in the Americas but also elsewhere in the internation-al community. In this regard, NAFTA symbolized theway forward in trade liberalization.

These expectations were obviously exaggerated, ifnot unfounded, as in the case of the reduction ofmigration flows. Moreover, if negotiations in NorthAmerica did in fact have direct impacts on theUruguay Round and its results, the US trade agendaquickly encountered strong resistance – beginning inthe Americas where negotiations were finallydropped because of a lack of consensus (Summit ofMar del Plata), but also in the case of APEC and atthe WTO (Deblock 2007). Worse, by engaging in abilateral path, the United States somehow freedeveryone the obligation to favor multilateralism,thus opening a true Pandora’s box. In this regard,the disastrous Ministerial Conferences in Seattle(1999) and Cancun (2003) were turning points.Apart from the fact that they revealed the gap

CESifo Forum 4/2010 10

Focus

1 Integration is said to be positive when it is oriented towards com-mon goals and shallow when it is limited to trade.

2 The Security and Prosperity Partnership , established in 2005,helped open discussions on new areas including energy, transportand certain regulations, but its primary intention was to strengthensecurity at the borders and facilitate passage thereof.

Page 13: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201011

Focus

between US positions and thoseof emerging countries, they de-monstrated the impossibility ofa multilateral consensus in-evitably leads to a multiplicationof bilateral and regional chan-nels as the default solution. TheUnited States is not solelyresponsible for the proliferationof the spaghetti bowl of tradeagreements, but the doctrine of‘competitive liberalization’,which, under the presidency ofGeorge W. Bush, replaced re-gional blocks and their disinter-est in multilateralism, onlyadded fuel to the fire. What isstriking today is not so much therace towards trade agreementsbut rather the new form they take. We have entered athird wave of regionalism, marked both by the pro-liferation of agreements in Asia, a region that longremained outside this trend, and by the emergence ofa different model that we call a ‘partnership’ model,initiated mainly by China, a new player that everyday affirms and reaffirms its ambitions to shape theworld economy (Beeson 2007).

The two periods of NAFTA

NAFTA is often criticized, often severe when it comesto jobs and working conditions (Faux, Salas andSchott 2006), but its overall record clearly remains pos-itive, far more so in fact than was initially anticipated(Courchene 2003; Hufbauer 2008; Pacheco-López2008). First, it established an institutional framework

conducive to trade, to the great satisfaction of the busi-ness world. Some disputes – timber, transportation andsugar for instance – regularly reappear, but they remainfew given the magnitude of trade. Similarly with dis-putes relating to investment: they remain isolated casesand arbitration decisions are too uncertain to allowstrong conclusions to be drawn from them.Furthermore, trade between the three countries experi-enced a sharp rise. Between 1992 and 2008, exportsfrom Canada and Mexico to the United States weremultiplied respectively by 3 and 4.5, while their importsfrom the United States have been multiplied by 2.5 and3. As for trade between Canada and Mexico, it hasbeen multiplied by 6. Finally, even if NAFTA did notbegin auspiciously (Zapatista uprising on 1 January1994 and the peso crisis by the end of that year),Mexico recuperated quickly from the crisis, and experi-enced strong growth led by exports and a booming

maquilas industry. Thus, the num-ber of jobs in these industries dou-bled between 1995 and 2000 from648,263 to 1,291,232.3 Anothercompelling fact is that the share ofthe manufacturing sector in totalexports went from less than halfthe total before NAFTA to morethan 80 percent in the early 2000s(Waldkirch 2008).

One of NAFTA’s most notewor-thy effects was to significantlystrengthen the trade links

Table 2

Exports and imports of goods and services 1970–2009

(% of GDP)

ExportsPeriod

Canada Mexico United States

1970–79

1980–89

1990–99

2000–09

23.3

27.0

34.2

39.0

8.1

17.1

21.5

26.9

7.5

8.5

10.5

10.9

ImportsPeriod

Canada Mexico United States

1970–79

1980–89

1990–99

2000–09

22.8

25.2

32.7

35.2

10.7

13.6

23.1

28.6

7.7

10.3

11.9

15.7

Source: United Nations Statistics Division.

Table 3Growth of US merchandise trade with Canada and Mexico 1980–2009

(average annual growth rate in %) Exports to Period

Canada Mexico 1985–89 1990–94 1995–99 2000–04 2005–09

8.7 7.6 7.9 2.9 2.4

16.6 15.7 12.1 5.8 3.7

Imports from Period Canada Mexico

1985–89 1990–94 1995–99 2000–04 2005–09

6.0 8.0 9.0 5.6

– 0.9

8.9 13.2 17.3 7.9 3.3

Source: Bureau of Economic Analysis (BEA), US International Trans-actions Accounts Data.

3 Source: INEGI.

Page 14: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

between the three countries. It isnecessary, however, to distinguishbetween the period prior to andafter 2000. Before 2000, tradegrew rapidly. Thus, the share ofintra-NAFTA trade between1994 and 2000 went from 45 per-cent to 56 percent for exports andfrom 37 percent to 40 percent forimports.4 Thereafter, the share ofintra-NAFTA exports remainedstable until 2005, but then beganto recede slowly before droppingto 48 percent since the 2008 crisis.The decline is felt even moreacutely in the import sector.From 40 percent, the share ofintra-NAFTA imports droppedto 38 percent in 2005 and then to33 percent in 2009. Clearly, tradeis slackening and three reasonsexplain this. First, Canada andMexico benefited from twoadvantages during the 1990s:strong growth in the UnitedStates and weak currencies.These have disappeared as theUS economy has lost momentumand the crisis of 2008–2009 hassharply driven down bilateraltrade while the Canadian dollarachieved near-parity with the USdollar and the peso’s real valuerose sharply. Both Canada andMexico have lost competitive-ness, at least in terms of prices(Morales 2010).

Furthermore, trade conditions have dramaticallychanged since China’s accession to the WTO. Chinesecompetition is felt at two levels: both within theUnited States (the main market for Canada andMexico), and in these two countries as well whereChinese products are challenging local industries andimports from the United States. Thus, between 1996and 2008, we have witnessed the share of importsfrom China growing from 2.1 percent to 10.1 percentof total imports in Canada, from 0.8 percent to10.7 percent in Mexico and from 6.6 percent to16.5 percent in the United States.5 Conversely, whileUS exports to China rose from 1.9 percent to 6.5 per-

cent between 1996 and 2008, this was not the case for

Canada and Mexico: Canada’s exports to China rose

only from 1.1 percent to 2.5 percent and Mexico’s,

from 0.2 percent to 0.7 percent. But what do we have

to offer to China? While Canada has natural

resources and cutting-edge industries in certain sec-

tors, Mexico does not have the advantage of natural

resources, with the exception of petroleum, and its

industries are still very fragile and dependent on inte-

gration with the United States while it is especially

exposed to Chinese competition, with the exception of

the automobile industry (Meza and Salvador 2009;

Rosales and Kuwayama 2007; Arès 2005).

Finally, the third source of concern is the changes in

the direction of direct investments. In Canada, this

phenomenon was observed long ago: in 1994, two

thirds of direct investments (FDI) came from the

CESifo Forum 4/2010 12

Focus

40

50

60

70

80

90

100

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Exports

Imports

Sources: Statistics Canada, Canada's Balance of International Payments, Catalogue 67-001; Mexico, Ministry of Economy, Underministry of Foreign Trade.

CANADA AND MEXICO MERCHANDISE TRADE WITH THE US 1989–2009

% of total trade

Mexico

Canada

60

80

100

120

140

1993 1995 1997 1999 2001 2003 2005 2007 2009

Canadian dollar

Mexican new peso

Source: Federal Reserve Bank of St Louis.

REAL EXCHANGE RATES Mexican new pesos and Canadian dollars to one US dollar

1993 = 100

Figure 1

Figure 2

4 Source: WTO.5 Source: United Nations, ComTrade.

Page 15: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201013

Focus

United States. By 2009, only half did, whileCanadian FDI in the United States went from 53 per-cent to 44 percent of total Canadian FDI abroad.But it is on the US side that the changes are most

notable. China and Asia general-ly attract few Canadian compa-nies, but this is not the case forUS companies which have longbeen established in this part ofthe world. Figure 3 is very reveal-ing, giving us the number of jobsin US subsidiaries (affiliates) inCanada, Mexico and China forthe manufacturing sector. Itclearly shows that althoughNAFTA originally stimulatedjob creation in both Canada andMexico, that trend has since beenreversed (Blecker 2009).

These contrasting trends revealtwo things. First, NAFTA hasgiven new impetus to economicgrowth in Canada and Mexicobut it has also had the perverseeffect of reinforcing their natur-al dependence on the UnitedStates. Second, changes in theinternational economic environ-ment have forced both countriesto rethink their economicstrategies, so far much toofocused on the United States(Goldfarg 2006).

Productivity – the weak link

Did NAFTA divert the attentionof Canadian and Mexicanauthorities from consideringother markets and partners? Onecan think so. On the one hand,the agreement was most satisfac-tory as trade was extremelyfavorable to Canada and Mexicothat benefitted from large tradesurpluses year after year. On theother hand, even when bothcountries sought to diversifytheir trade, their efforts did notyield the expected results sincecompanies did not really re-

sponded, and because the failure of the FTAA pro-ject revealing the failure of their economic diploma-cy on the continent. This being said, times havechanged. The United States, increasingly tied up with

Table 4US merchandise trade with major partners 1980–2009

(average share of total trade in %)Exports to Period

Canada Mexico Japan China 1980–89 1990–99 2000–09

22.4 22.3 21.9

6.2 9.8 12.9

10.8 10.1 6.2

1.5 1.8 4.6

Imports from Period Canada Mexico Japan China

1980–89 1990–99 2000–09

19.1 19.3 16.9

5.4 8.6 10.9

18.4 15.6 8.5

1.4 6.2

13.9 Source: Bureau of Economic Analysis (BEA), US International Trans-actions Accounts Data.

0

100

200

300

400

500

600

700

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Canada

Mexico

China

Source: US Bureau of Economic Analysis.

US MAJORITY-OWNED FOREIGN AFFILIATES, EMPLOYMENT 1997–2008Total manufacturing, 1 000 employees

80

90

100

110

120

130

140

1991 1993 1995 1997 1999 2001 2003 2005 2007

CanadaMexicoUnited States

Source: OECD Factbook 2010: Economic, Environmental and Social Statistics.

LABOUR PRODUCTIVITY GROWTH 1991–20081991 = 100

Figure 3

Figure 4

Page 16: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

China, shows little interest in the Americas whileChina has become a major player in the Americas inonly a decade. Both Canada and Mexico are now upagainst a wall: how can they preserve their marketshares within North America while gaining shares inother markets, if not through innovation and invest-ment in the future?

Low productivity has indeed become a major concernin Canada and Mexico; no doubt does it also explainto a large extent the problems of competitiveness thatboth countries are faced with today. In this regard,Figure 4 and Table 5 are most revealing about threethings. First, the hopes for convergence have not beenrealized by NAFTA: Mexico has not reduced its pro-ductivity gap with the United States and, since 2000,Canada has seen this gap widening. Second, the rateof productivity growth has been falling dramaticallysince 2000, far more than in the United States. Andthird, at least for Canada, this gap is mainly due to theMFP (multi-factor productivity). Many reasons havebeen given to explain this fact, but they all converge inthe same directions: (1) low exchange rates combinedwith large trade surpluses have not encouraged firmsto invest as much as they should have, and have led topoor economic decisions; (2) companies have laggedbehind in implementing new technologies and invest-ing capital, largely because of weak demand for inno-vation and insufficient pressure from competition;and (3) political authorities have not been sufficientlyreactive in terms of research and development, inno-vation and education (Ibarra 2010; Ito 2010; Dion2007; Fujii, Candaudap and Gaona 2005; Sharpe andArsenault 2008).

One of the great objectives of Canada and Mexicowas to use the US market as a springboard, and they

both expected free trade to boost competitiveness.Both economies have opened outwards significantlyas the share of trade in GDP increasing from 26 per-cent to 37 percent between the 1980s and 2000s inthe case of Canada, and from 15 percent to 27 per-cent for Mexico. But, this opening has largely beendue to integration trade with the United States andit has not spurred much growth as was expected. Oneshould be cautious in this respect. It would be disin-genuous to say that NAFTA did not producedynamic effects. Quite the contrary, as evidenced bythe very high ranking of Canada’s CompetitivenessIndex of the World Economic Forum (10th) or, inthe case of Mexico, the technological composition ofexports, higher than that of Canada. Even though,the fact remains that both countries suffer from seri-ous weaknesses in innovation and investment, withMexico even receding on the scale of global compet-itiveness (66th in 2010). All in all, if a cause must befound for the difficulties faced by both countries indiversifying their trade, it lies in the shortcomings ofboth governments and businesses and not inNAFTA primarily.

This is indeed one of the great lessons to be learnedfrom the experience of NAFTA. Trade liberalizationoffers windows of opportunity and in this sense,NAFTA, by creating an environment favorable totrade, has allowed Canada and Mexico to seize thisopportunity, and turn North American to theiradvantage. Of course, we cannot compare Canadaand Mexico, still an emerging country which, despitethe reforms, still suffers from economic rigidities,structural weaknesses and severe inequalities. But itis also clear that in order to lead to results a policyof export-led growth must be supported by invest-ments and endogenous growth policies which priori-

CESifo Forum 4/2010 14

Focus

Table 5

Labour productivity, levels, growth rates and contribution to GDP growth

Levels of GDP

productivity 2008

GDP

productivity

growth rate

Contribution to

GDP growth

per

capita

per hour

worked

per hour worked

US dollars, current

prices and PPPs,

US = 100

1995–

2000

2001–

2008

GDP

growth

1985–

2008

Labour Capital Multi-factor

productivity

United States

Canada

Mexico

Chile

OECD

100

83

31

31

71

100

78

34

28

76

2.38

2.26

1.95

2.33

1.96

0.72

0.45

1.44

1.70

2.89

2.65

2.80

5.60

0.94

1.19

0.86

1.10

1.09

0.37

Source: OECD Factbook 2010: Economic, Environmental and Social Statistics.

Page 17: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201015

Focus

tize innovation, research and education, without

neglecting the domestic market (Zeda, Wise and

Gallagher 2009).

Conclusion: time for a change?

NAFTA will turn twenty in 2013. It should be given

credit for having significantly strengthened economic

ties among Canada, the United States and Mexico

and thus to have contributed to the revitalization of

national economies. It is, however, far from having

achieved all the objectives that the governments were

aiming at when they signed the agreement. One can

identify gaps and deficiencies in this integration

model, especially in terms of economic and political

convergence as well as in terms of inequalities, which

remains a problem. One can also point to the limits of

a trilateral cooperation that is far too circumscribed

for adequate management of the agreement and to

the fact that it triggered a proliferation of trade agree-

ments that led to a messy international trading sys-

tem. But the focus of this article is not so much to

address these shortcomings of NAFTA as to empha-

size the fact that while well adapted to the context of

the 1990s, NAFTA is much less adapted to the reality

of the 2000s. Is the NAFTA model running out of

breath? One can readily answer ‘YES’.

To put it simply, there is a before 2000 and an after

2000. The institutional model of NAFTA is now

much less convincing than it was in the 1990s. As a

model of integration, it is also weakened by changes

in international economic trends. Both in Canada and

Mexico, the stimulating effects of regional integration

seem exhausted or, at least, insufficient to stimulate

investment and productivity. Economic conditions

have changed: neither Canada nor Mexico can now

count on the US locomotive, let alone surf on a favor-

able exchange rate as before. In both Canada and

Mexico, the dramatic drop in bilateral trade with the

United States in 2009 was cause for concern.

Although trade has indeed resumed vigorously in

2010, these worries remain. Fear, as they say, is the

beginning of wisdom. Or at least, in these spreading

concerns, the crisis should be credited for reminding

us not only that competitiveness is built first at home,

but also that regional integration cannot be reduced

to a simple exercise in trade diplomacy. NAFTA is

certainly out of breath and even outdated, but too

many interests are at stake and the current challenges

are too important to let things go astray (Schott 2008;

Alexandroff, Hufbauer and Lucenti 2008). In this

sense, the crisis offers an opportunity to redefine the

framework of regional cooperation, and to rethink

terms of integration that do not rely primarily on

market forces, as it has been the case until now.

References

Alexandroff, A.S., G.C. Hufbauer and K. Lucenti (2008), “StillAmigos: A Fresh Canada-US Approach to Reviving NAFTA”,Commentary 274, C. D. Howe Institute, Toronto.

Arès, M. (2005), “Du triomphe à l’inquiétude. L’industrie maquiladans la tourmente”, in: Rioux, M. (ed.), Mondialisation et pouvoir desentreprises, Collection Économie politique internationale, Montréal:Éditions Athéna, 215–242.

Beeson, M. (2007), Regionalism and Globalization in East Asia:Politics, Security and Economic Development, Houndsmill: PalgraveMacmillan.

Blecker, R.A. (2009), “External Shock, Structural Changes, andEconomic Growth in Mexico, 1979–2007”, World Development 37,1274–1284.

Brunelle, D. and C. Deblock (1989), Le libre-échange par défaut,Montreal: VLB éditeur.

Courchene, T (2003), “FTA at 15, NAFTA at 10: A CanadianPerspective on North American Integration”, The North AmericanJournal of Economics and Finance 14, 263–285.

Deblock, C. (2007), “Il était une fois dans les Amériques... Le projetenvolé de zone de libre-échange”, Europa & America Latina 2,105–132.

Deblock, C. and S. Turcotte (2003, eds.), Suivre les États-Unis ouprendre une autre voie? Diplomatie commerciale et dynamiquesrégionales au temps de la mondialisation, Bruxelles: Éditions Bruylant.

Dion, R. (2007), “Interpreting Canada’s Productivity Performance inthe Past Decade: Lessons from Recent Research”, Bank of CanadaReview, Summer, 19–32.

Faux, J.,C. Salas and R.E. Scott (2006), Revisiting NAFTA: Still NotWorking for North America’s Workers, EPI Briefing Paper, EconomicPolicy Institute, Washington DC.

Fujii, G., E. Candaudap and C. Gaona (2005), “Salarios, productivi-dad y competitividad de la industria manufacturera Mexicana”,Comercio Exterior 55, 16–28.

Gagné, G. (2001), “The Investor-State Provisions in the AbortedMAI and in NAFTA: Issues and Prospects”, The Journal of WorldInvestment 2, 481–505.

Goldfarg, D. (2006), “Too Many Eggs in One Basket? EvaluatingCanada’s Need to Diversify Trade”, Commentary 236, C. D. HoweInstitute, Toronto.

Hufbauer, G. (2008), “NAFTA’s Bad Rap”, The InternationalEconomy, Summer, 19–23.

Ibarra, C.A. (2010), “Exporting without Growing: Investment, RealCurrency Appreciation, and Export-Led Growth in Mexico”, TheJournal of International Trade & Economic Development 19, 439–464.

Ito, T. (2010), “NAFTA and Productivity Convergence betweenMexico and the US”, Cuadernos de Economia 47/May, 15–55.

Lawrence, R.W. (1996), Regionalism, Multilateralism, and DeeperIntegration, Washington DC: The Brookings Institution.

Meza, L. and J. Salvador (2009), “La dinámica del comercio exteriorde México y China”, Comercio Exterior 59, 615–628.

Morales, I. (2010), Post-NAFTA North America, Houndmills:Palgrave Macmillan.

Pacheco-López, P. (2008), “Foreign Direct Investment, Exports andImports in Mexico”, World Economy 28, 1157–1172.

Rosales, O. and M. Kuwayama (2007), “Latin America Meets Chinaand India: Prospects and Challenges for Trade and Investment”,CEPAL Review 93, 81–103.

Page 18: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

Schott, J.J. (2008), The North American Free Trade Agreement: Timefor a Change?, Washington DC: Peterson Institute for InternationalEconomics.

Sharpe, A. and J.F. Arsenault (2008), The Canada-US ICT InvestmentGap: An Update, CSLS Research Report 2008-1, Ottawa.

Waldkirch, A. (2008), The Effects of Foreign Direct Investment inMexico since NAFTA, MPRA Paper 7975.

Weintraub, S. (1990), A Marriage of Convenience: Relations betweenMexico and the United States, New York: Oxford University Press.

Zeda, E., T.A. Wise and K.P. Gallagher (2009), “Rethinking TradePolicy for Development: Lessons from Mexico under NAFTA”,Policy Outlook, Carnegie Endowment for International Peace,Washington DC.

CESifo Forum 4/2010 16

Focus

Page 19: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201017

Focus

NAFTA, TRADE AND

DEVELOPMENT

ROBERT A. BLECKER* AND

GERARDO ESQUIVEL**

Introduction

In 1990, Mexican President Carlos Salinas de Gortariand US President George H.W. Bush announced theirintention to sign a free trade agreement (FTA)between their two countries. After the government ofCanada joined this effort a year later, the three coun-tries began negotiations to establish what was thencalled the largest free trade area in the world. Themere announcement of this effort, which led to theformation of the North American Free TradeAgreement (NAFTA) in 1994, immediately sparked aseries of debates along multiple dimensions. InMexico and the United States, the domestic discus-sion focused on the economic impact of engaging inan FTA with a highly asymmetrical partner that couldeither destroy domestic industries due to its techno-logical superiority (as was expected in Mexico) or gen-erate massive job losses in response to lower wagesacross the border (as was expected in the UnitedStates). Of course, proponents of NAFTA dismissedthese fears and instead emphasized the benefits of freetrade in terms of efficiency, productivity and greatervariety of products for consumers.1

At a more general level, the announcement of the cre-ation of NAFTA also generated a heated debateabout regionalism versus multilateralism in tradenegotiations, since it was seen as a step forward in thecreation of a large trading bloc that could affect nego-

tiations leading towards full multilateral trade liberal-

ization. From a slightly different perspective, NAFTA

was seen as a geopolitical move that was a natural US

response to European integration efforts, and

although it was probably not going to have a pro-

found impact on the US economy, it could have one

on the Mexican. NAFTA was also seen by many as a

radical departure from the protectionist policies tradi-

tionally followed by Mexican policy makers that

could eventually lead to closing the historical devel-

opment gap between Mexico and its northern neigh-

bors. For that reason, NAFTA generated huge expec-

tations among analysts interested in understanding

the economic impact of an FTA between highly

asymmetrical partners.

In this paper, we analyze the expectations and the

realities about the economic impact of NAFTA on

Mexico in terms of economic convergence, trade,

investment, employment, wages, and income distrib-

ution. We show that NAFTA has basically failed to

fulfill the promise of closing the Mexico-US devel-

opment gap, and we argue that this was due in part

to the lack of deeper forms of regional integration or

cooperation between Mexico and the United States.

We also explore other factors that could explain this

negative outcome, and we briefly discuss the oppor-

tunities for both Mexico and the United States to

mutually benefit from a further economic integra-

tion process.

NAFTA expectations and realities

The Mexican government had pinned its hopes on

NAFTA not merely to boost exports to the US and

Canadian markets, but also to attract large amounts

of foreign direct investment (FDI), create a significant

number of new industrial jobs, and give the Mexican

economy the growth stimulus it had been lacking

since the tepid recovery from the debt crisis of the

1980s (Lustig 1998). President Salinas famously pre-

dicted that NAFTA would permit Mexico to ‘export

goods, not people’ and to join the ranks of ‘first-

world’ nations. NAFTA’s critics in the United States

predicted that it would cause a massive relocation of

* American University, Washington DC.** El Colegio de México, Mexico City.An earlier version of this paper was presented at the workshop onMexico and the United States: Confronting the Twenty-First Centuryheld at the Center for US-Mexican Studies, University of California,San Diego, July 2009. The workshop was co-sponsored by theMexico Institute of the Woodrow Wilson Center (Washington), ElColegio de la Frontera Norte (Tijuana), and El Colegio de México(Mexico City), along with the Center. The authors would like tothank the workshop participants for their helpful comments andsuggestions.1 For a discussion of the US debate about NAFTA around the timeof its passage, see Cohen, Blecker and Whitney (2003).

Page 20: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

US industries and jobs to Mexico, while fosteringgreater inequality in both societies by creating a ‘raceto the bottom’ in social and labor standards. NAFTAsupporters in turn promised that the agreement wouldstimulate US employment via trade surpluses with agrowing Mexican market. Paradoxically, NAFTA’soriginal supporters and opponents seemed to agreethat, whatever else it would do, this agreement wouldgive a major impetus to Mexico’s industrial develop-ment and job creation.

Of course, NAFTA did not go into effect in a vacu-um, and it is perilously difficult to disentangleexactly what were the effects of this trade agreementrelative to other factors in the post-1994 evolutionof the two economies. NAFTA built upon the baseof the much larger tariff reductions and more far-reaching market-opening measures that Mexico hadalready adopted unilaterally after it joined theGeneral Agreement on Tariffs and Trade (GATT) in1986, so not all of the effects of trade liberalizationcan be attributed to NAFTA.2 In addition, macro-economic factors such as financial crises, exchangerates, oil prices, and business cycles were importantdeterminants of what actually occurred.3 Sub-sequent trade agreements, both multilateral (the for-mation of the World Trade Organization) and pref-erential (the many other FTAs entered into sepa-rately by Mexico and the United States), reducedthe significance of the tariff preferences containedin NAFTA. China’s emergence as a global econom-ic power and the rapid increase in its share of NorthAmerican markets have also had an enormousimpact on the region.

The fact that NAFTA was never supplemented bydeeper forms of regional integration, social policies,or economic cooperation probably limited the bene-fits and exacerbated the costs (Pastor 2001; Studerand Wise 2007). Domestic policies in both nationsmattered, as did underlying geographic and demo-graphic realities. US efforts to stem unauthorizedimmigration, coupled with post-September 11 securi-ty measures, have made the border tougher, not easi-er, to cross, even for legal goods and services. As aresult of all these factors, it is safer to analyze whathappened after NAFTA than what happened because

of NAFTA, but we will try to draw some inferencesabout causality where the evidence permits.

In fact, the trajectories of the US and Mexicaneconomies after NAFTA bear little resemblance toany of the more exaggerated forecasts on either side.NAFTA did not solve Mexico’s employment prob-lems, raise its average real wages, or reduce migrationflows, and it seems to have done little to raise thecountry’s long-run average growth rate, although itcontributed to a strong recovery from the 1994–1995peso crisis and a short-lived boom in 1996–2000.Mexico did reap gains in exports, FDI, and other indi-cators, especially in the late 1990s, but NAFTA didnot turn out to be the panacea promised by theSalinas administration.

The United States did not suffer a catastrophic lossof manufacturing employment immediately afterNAFTA went into effect, although it began to hem-orrhage manufacturing jobs more severely after theAsian financial crisis of 1997–1998 and the surge inChinese imports beginning around 2001. US work-ers made significant real wage gains in the late 1990sin spite of increasing US trade with Mexico, whileMexican workers suffered a sharp decline in realwages following the 1994–1995 peso crisis that wasonly barely reversed by the early 2000s. During thefirst seven years of NAFTA (1994–2000), NorthAmerica showed signs of becoming a more integrat-ed and competitive regional market area, but muchof the progress on the regional front was reversed inthe next eight years (2001–2008), as we shall seebelow.

NAFTA and economic convergence

When NAFTA was signed, one of the main objectivesof the agreement (at least from the Mexican perspec-tive) was to achieve a reduction in the historical gap ofeconomic development between Mexico and theUnited States. Despite of all the anti-Americanrhetoric traditionally displayed by Mexican politi-cians4, the truth is that many Mexicans have longaimed to benefit from being close to one of the biggestand richest markets in the world. Of course, thisexplains not only the large flows of migrants fromMexico to the United States, but also the close tradeties that have been established historically between thetwo countries. In that sense, when NAFTA was signed

CESifo Forum 4/2010 18

Focus

2 Furthermore, NAFTA contained many provisions that wentbeyond trade liberalization, such as guarantees of property rights forforeign investors, and was also intended to lock-in Mexico’s previousmarket reforms. In this sense, NAFTA may have had consequencesbeyond the direct effects of the reductions in trade barriers it con-tained.3 For an analysis of the impact of these macroeconomic factors onMexico, see Blecker (2009).

4 Remember, for example, the famous expression attributed toMexican dictator Porfirio Díaz: “Poor Mexico, so far from God, andso close to the United States!”

Page 21: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201019

Focus

there were huge expectations thattrade and FDI could help toreduce the Mexico-US economicgap. From the perspectives ofboth countries, this could bringabout multiple benefits for every-one involved in the agreement:for Mexican workers, this wouldimply higher wages and a betterstandard of living; for Ameri-cans, this would imply having amore stable and economicallysound neighbor that could alsobecome a good client for US-made products. Under this sce-nario, Mexican workers wouldhave lower incentives to migrateand, since migration has always generated a heateddebate in some segments of the US population, thiscould also help to ease tensions in the Mexican-USrelationship. All in all, NAFTA would be a win-winsituation.

The relevant question, then, is what has happened tothe historical Mexico-US economic development gapsince (or as a result of) NAFTA? Has there been eco-nomic convergence between Mexico and the UnitedStates since (or as a result of) NAFTA?5

Figure 1 provides the answer to these questions.The graph shows alternative long-term measures ofincome per capita or income per worker in Mexicoas percentages of the corresponding measures inthe United States. The data are shown in relativeterms to better capture the idea of economic con-vergence: if income per capita in Mexico increasesrelative to that in the United States, the relativevariables will rise and we would then conclude thatthere was a process of economic convergencebetween the two countries. Otherwise, we would saythat there was no convergence. Indeed, if the rela-tive variables decline, we would then say that therewas a process of economic divergence between thecountries.

Figure 1 shows data from two different sources: theWorld Bank (WB) and the Penn World Tables v. 6.3(PWT), and it shows two indicators from each source.From the WB we use the series on GDP per capita inpurchasing power parity terms (PPP), which adjustsfor price differentials across countries (this is theseries WB GDP per capita, PPP) as well as the serieswithout adjustment (WB GDP per capita).6 Bothvariables are measured as ratios of data in currentprices. From the PWT we also use two series: the firstis the Mexico-US ratio of real income per capita(PWT real GDP per capita) and the second is the ratioof real GDP per worker (PWT real GDP per worker).Both variables are measured as ratios of data in con-stant prices.

All four series show essentially the same result: the levelof economic development in Mexico relative to theUnited States has been remarkably stable since 1995,which means that there has been no economic conver-gence between these two countries as a result of (orassociated with) NAFTA. Notice that, even after therecovery from the 1994–1995 crisis, the level of eco-nomic development in Mexico relative to the UnitedStates (in either per capita or per worker terms)remained slightly below what it was before the passageof NAFTA. The data in Figure 1 show that Mexico’sincome per capita is about one fourth (WB, PPP terms)or one third (PWT) of the US income per capita,depending on which source we use. The figure alsoshows that output per worker in Mexico relative to theUnited States has steadily declined since 1981 and thatit is now just slightly above 30 percent. For comparison

5 Note that the term economic convergence as used in this paper isdifferent from how the term has been used in some other studies, par-ticularly Lederman, Mahoney and Servén (2005), and Haber, Klein,Maurer and Middlebrook (2008). These studies utilize a counterfac-tual analysis of the type: is Mexico better-off with NAFTA thanwithout it? Or, could the Mexico-US gap have been greater in theabsence of NAFTA? The former study includes a time-series analy-sis that investigates whether Mexico is converging toward a constantper capita income differential with the US (i.e. 50 percent of the USlevel). Economic convergence for us means a reduction in theabsolute Mexico-US gap in terms of the variables that affect eco-nomic well-being, such as income per capita, average wages, andlabor productivity, and the eventual approach of Mexico to US lev-els of these variables.

0

10

20

30

40

50

60

70

80

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

WB GDP per capita WB GDP per capita, PPP PWT real GDP per capitaPWT real GDP per worker

Sources: Penn World Tables (PWT) 6.3; World Bank, World Development Indicators.

MEXICO S ECONOMIC PERFORMANCE RELATIVE TO THE US% NAFTA

,Figure 1

6 We include the latter variable only as a reference. It is more accurateto use PPP data when making international comparisons of livingstandards.

Page 22: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

purposes, note that this ratio wasclose to 40 percent in 1993, beforeNAFTA went into effect.

In sum, the data show that therehas been no economic conver-gence whatsoever between Mexi-co and the United States sinceNAFTA’s enactment. As a result,the historical Mexico-US eco-nomic gap in percentage termshas not been reduced after15 years of free trade, and theincentives to migrate are proba-bly even greater than before sincethe income gap in absolute termsis now larger that it was 15 yearsago. Furthermore, since therecent international financial crisis has affectedMexico more than any other country in the WesternHemisphere7, we can anticipate that the Mexico-USgap increased even further in 2008–2009.

Trade and investment flows

This lack of convergence did not occur because of afailure of trade to grow faster after NAFTA went intoeffect. On the contrary, Table 1 shows that US non-petroleum imports from Mexico accelerated to anaverage annual growth rate of 19.5 percent in the firstseven years of NAFTA (1993–2000), after growing atan already rapid clip of 13.9 percent in 1987–1993 fol-lowing Mexico’s unilateral liberalization. As a resultof this faster growth, Mexico’s share of US non-petroleum imports climbed from 6.7 percent in 1993to 11.4 percent in 2000. The accelerated growth in1993–2000 should not be attributed entirely toNAFTA, however, but also resulted from two otherfactors: the ‘new economy’ boom in the United Statesin the late 1990s, which led to an enormous explosionof US demand for imports generally; and the depreci-ation of the Mexican peso following the 1994–1995peso crisis, which left the peso at a more competitiveexchange rate for the next several years.

However, US import growth from Mexico slowedconsiderably after 2000. US non-petroleum importsfrom Mexico grew only at a 4.9 percent annual rate in2000–2008, while US imports from China continued

to soar at a torrid 16.4 percent annual pace duringthat period. To be sure – and this is where bothNAFTA and geography may have helped – Mexicosucceeded in maintaining its US market share betterthan other global regions in the 2000–2008 period.The 11.3 percentage point increase in the Chineseshare of US non-petroleum imports during this peri-od came mostly at the expense of other countries,while Mexico’s share dipped only slightly.Nevertheless, it is likely that US imports from Mexicowould have grown much faster and increased theirshare further after 2000 in the absence of the rapidinflux of imports from China.8

The disappointing growth of Mexican exports to theUnited States in 2000–2008 occurred after Chinajoined the World Trade Organization (WTO) andobtained ‘permanent normal trade relations’ (former-ly known as ‘most favored nation’) status from theUnited States in 2001. However, other factors werealso at work. As part of its inflation-targeting mone-tary policy, the Mexican government allowed thevalue of the peso to rise significantly in the early2000s.9 The end of the Multifibre Arrangement(MFA) in 2005 led other developing countries (large-ly, but not exclusively, China) to increase their sharesof global textile and apparel production, therebydestroying a large part of the vertically integratedNorth American textile-apparel complex that flour-ished briefly under NAFTA’s rules of origin in the late

CESifo Forum 4/2010 20

Focus

Table 1

US non-petroleum imports from Mexico, China and other countries

Percentage share in total US non-petroleum imports

1987 1993 2000 2008

Mexico 4.5 6.7 11.4 11.1China 1.7 5.9 9.0 20.3Other countries 93.8 87.4 79.6 68.6Total 100.0 100.0 100.0 100.0

Growth (average annual percentage rates)

1987–

1993

1993–

2000

2000–

2008

Mexico 13.9 19.5 4.9China 30.8 17.9 16.4Other countries 5.4 9.4 3.3Total 6.6 10.9 5.2

Sources: US Bureau of Economic Analysis, International Transactions

Accounts; Petróleos Mexicanos (PEMEX), Anuario Estadístico (various

years); authors’ calculations.

7 Mexico’s per capita GDP in 2009 is estimated to fall by about 8 percent, whereas US per capita GDP is expected to fall by at most3 percent.

8 For evidence of significant displacement of Mexican exports byChinese exports, see Gallagher, Moreno-Brid and Porzecanski (2008),Hanson and Robertson (2009) and Feenstra and Kee (2006).9 See Galindo and Ros (2008) for evidence that the Banco deMéxico’s monetary policy was biased toward permitting the peso toappreciate in the early 2000s.

Page 23: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201021

Focus

1990s. High-tech producers alsodiscovered that they could findlower wages and more supportivegovernment policies in variousEast Asian countries (Gallagherand Zarsky 2007).

Mexico’s trade data show a simi-lar pattern of regional integrationincreasing during the 1993–2000period and then diminishingthereafter (see Table 2). On theexport side, the largest increase inthe US share of Mexican exportsoccurred in 1987–1993; this sug-gests the natural pull of geogra-phy in stimulating intra-regionaltrade even when Mexico openedup its own economy unilaterally.10

In spite of efforts by Mexico todiversify its export outlets, espe-cially through the signing ofnumerous other bilateral FTAs,80.2 percent of Mexican exportswere still sold in the US market asof 2008.

In contrast, the US share ofMexican imports remained rela-tively stable at around 70 percentfrom 1987 through 2000, andthen fell abruptly to 49 percent in2008. There were several causesof this sharp reduction in intra-regional trade post-2000. First,since both the US dollar andMexican peso were at relativelyhigh values during the first sever-al years of the 2000s, producersthroughout North America hadstrong incentives to source prod-ucts (both final and intermediategoods) outside the continent. Second, the penetrationof Chinese and other Asian imports into the US mar-ket not only displaced Mexican exports to the UnitedStates, but also displaced US exports of intermediategoods that would otherwise have been shipped intoMexico for assembly. Third, Mexican trade policyactively encouraged imports of intermediate goods

from outside the region through the Pitex program of

tariff exemptions.

Mexico did succeed in attracting a notably increased

average level of FDI inflows after NAFTA went into

effect in 1994 (Table 3). FDI inflows did not increase

continuously, however, but rather stabilized at an

average level of about 3 percent of GDP in the post-

NAFTA period. Interestingly, the proportion of US

FDI outflows that go to Mexico has not varied much

since the pre-NAFTA period (1987–1993), especially

Table 2

Country composition of Mexico’s external trade

(% share of total trade)a)

1987b)

1993 2000 2008c)

Exports: destination country

United States 69.2 82.7 88.7 80.2Canada 1.1 3.0 2.0 2.4China na 0.1 0.1 0.7Rest of world 29.7 14.2 9.1 16.7

Imports: country of origin

United States 74.0 69.3 73.1 49.0Canada 1.7 1.8 2.3 3.1China 0.2 0.6 1.7 11.2Other Asia 4.5 10.7 10.0 16.7Rest of world 19.6 17.6 13.0 20.0

a) Including maquiladora industries. –

b) The US percentages for 1987

were taken from Hufbauer and Schott (1992), Table 3.1, based on IMF,

Direction of Trade Statistics; 1987 data for other countries were esti-

mated using data from INEGI, Anuario Estadístico de los Estados

Unidos Mexicanos 95 (Aguascalientes: INEGI 1996) in combination

with Hufbauer and Schott’s percentages for the United States. –c)

Pre-

liminary figures.

Sources: Instituto Nacional de Estadística, Geografía e Informática

(INEGI) except for 1987; authors’ calculations.

10 It may seem paradoxical that Mexico’s liberalization of importsmade its exports to the United States grow so rapidly, but this seem-ing paradox is readily explained by the fact that the export productswere very intensive in imported intermediate goods, and also becauserestrictions on FDI were liberalized around the same time.

Table 3

Average inflows of foreign direct investment into Mexico

1987–

1993

1994–

2000

2001–

2007

Total inflows of FDI into Mexico

in billions of US dollars 3.2 12.4 22.4

as a share of Mexico’s GDP (%) 1.1 3.0 2.9

Inflows of FDI from

the United States into Mexico

in billions of US dollars 1.6 4.6 8.7

as a share of total US outflows

of FDI (%) 3.6 3.7 4.4a)

as a share of total FDI inflows

into Mexico (%) 61.0 61.7 54.7 a)

Excluding 2005 when the total was very low due to a large

adjustment for exchange rate changes; if we also exclude 2001 (when

Citibank bought Banamex) this figure would be 3.3%. If we include

both 2001 and 2005, the average for all years 2001–2007 amounts

to 7.5%.

Sources: IMF, International Financial Statistics; US BEA; INEGI; author’s

calculations.

Page 24: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

if we discount one unusually high year (2001, when Citibankacquired Banamex). The propor-tion of Mexican FDI inflowscoming from the United Statesfell in 2001–2007 compared withthe earlier periods shown, evenincluding 2001. Thus, Mexicohad more success in attractingadditional FDI from countriesoutside North America than itdid in attracting a larger share ofUS FDI outflows – and this mayalso have contributed to the fall-off in the US share of Mexico’simports after 2000.

Effects on manufacturing employment

US manufacturing employment did fall off a cliff –but not until after 2001, seven years after NAFTAwent into effect (see Figure 2). Roughly three millionmanufacturing jobs disappeared following the 2001recession and China’s accession to the WTO in thatyear, and another two million vanished in the finan-cial crisis and steep recession of 2008–2009. None ofthese events had anything to do with NAFTA orMexico, however, and, as we shall see below,Mexican manufacturing employment also fell inboth periods.

Nevertheless, it does not follow that NAFTA or US-Mexican trade had no negative impact on US manu-facturing employment, which might have beenexpected to have grown more during the economicboom of 1994–2000 than it actually did. US manu-facturing employment rose very little during thatperiod, in spite of GDP growth that averaged3.9 percent per year at that time. However, the high-est credible estimate of the cumulative US manufac-turing job losses that can be attributed to US-Mexican trade during (roughly) the first decade ofNAFTA is about 500,000, and other estimates arelower (some even claim net gains).11 Even taking thehigh-end estimate of about a half million jobs lostover a decade, it is a relatively small amount in acountry where payroll employment totaled 114 mil-lion in 1994 and reached 138 million in 2007, andsmaller than the monthly job losses during the worstof the recession of 2008–2009.12 Moreover, the500,000 figure is an estimate of job losses due to theincreased US trade deficit with Mexico, not effects ofNAFTA specifically.

If the US job losses that can credibly be attributed totrade with Mexico (if not to NAFTA per se) are rela-tively small, by the same token the employmentincreases that Mexico achieved in its tradable goodsindustries were much more modest than the moreoptimistic ex ante predictions. Total payroll employ-ment in Mexican manufacturing increased from2.5 million in 1989 to 2.9 million in 1994, and rose fur-ther to 3.8 million in 1999, but then declined to3.4 million in 2004.13 Overall, the net increase in man-ufacturing payroll employment in Mexico in the firstdecade after NAFTA (1994–2004) was roughly500,000 – perhaps coincidentally, just about the highend of the estimates of US job losses over the sameperiod. This a far cry from an amount of job creationthat could have put a serious dent in Mexico’s employ-ment needs (given that the labor force grows by near-ly 1 million workers annually) or stem the flow of emi-gration (which is estimated to have been in the rangeof about 350,000 to 580,000 per year in the 1990s andearly 2000s).14

CESifo Forum 4/2010 22

Focus

11 The high-end estimate comes from Scott, Salas and Campbell(2006), who calculate a net loss of 559,564 US jobs between 1993 and2004 as a result of the increased US trade deficit with Mexico. Incontrast, Hufbauer and Schott (2005) report that 366,000 US work-ers received certification of NAFTA-related job losses under theNAFTA Trade Adjustment Assistance (TAA) program between1994 and 2002; this number also includes jobs lost to Canada.Hufbauer and Schott (2005) argue that these job losses were morethan offset by gains in ‘jobs supported by exports’, but the latter arenot estimated by the same methodology used to calculate the joblosses. Neither study isolates effects of NAFTA as opposed to otherfactors.12 Total payroll employment data are from US Council of EconomicAdvisers (2009), Table B-46. The estimated job losses do loom larg-er relative to manufacturing employment, which was about 17 mil-lion in 1994 (see Figure 2).13 These data are from the Mexican Economic Census, which is con-ducted every five years; data for 2009 had not been released at thetime of this writing. These data were obtained from INEGI. OtherINEGI data, which are available on a monthly basis, show that mostof the job creation in manufacturing in the 1990s occurred in theexport-oriented maquiladora plants.14 The migration estimates are from Hanson (2006).

10

12

14

16

18

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: US Bureau of Labour Statistics.

TOTAL EMPLOYMENT IN US MANUFACTURUNG SECTORJanuary 1990–May 2009

seasonally adjusted Million

NAFTA

Finacial crisis

ChinajoinsWTO

Figure 2

Page 25: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201023

Focus

In retrospect, it should have been more obvious thattrade liberalization would not have had an enormousimpact on total industrial employment in Mexico.Trade liberalization increases imports as well asexports, and increased imports displace domestic jobsjust as much as increased exports create them. Thus,an important perspective on the disappointing jobgains in Mexico’s manufacturing industries can beobtained by examining the country’s trade balanceswith the United States and the rest of the world.While for the United States its growing deficit withMexico was part of a much larger increase in its over-all deficit, for Mexico its increasing surplus with theUnited States was completely offset by rising deficitswith other countries, primarily in Asia (see Figure 3).Furthermore, many Mexican export industries areessentially assembly operations that rely heavily onimported parts and components, and which lack‘backward linkages’ to domestic industries (Ruiz-Nápoles 2004; Moreno-Brid, Santamaría and Rivas

Valdivia 2005). As a result, theincreases in the gross value ofexports are an exaggerated indi-cator of value added and employ-ment generation in the exportindustries.

Income distribution, relative

wages and inequality

Figure 4 shows one of the mostwidely cited indicators of wageinequality, the skilled-unskilledwage gap, measured by the ratioof salaries of employees (non-production workers, in the USterminology) to wages of produc-

tion workers, from the monthly survey of non-maquiladora industries in Mexico. The sharp rise inthis measure of wage inequality in the first decade oftrade liberalization (1987–1997) surprised most econ-omists, since they had assumed that trade liberaliza-tion would boost the wages of less-skilled workers inMexico due to a supposed abundance of less-skilledlabor. One explanation for the rise in this ratio at thattime is that the initial tariffs which were lowered in thetrade liberalization of the late 1980s were higher in theindustries that were most intensive in less-skilled labor(Revenga and Montenegro 1998). Another explana-tion is that skill-biased technological change duringthis period boosted demand for more educated work-ers – although this shift may have been at least par-tially an effect of trade liberalization rather than anindependent cause.15

Of course, a rise in wage inequality that began sever-al years before NAFTA cannot be attributed to this

trade agreement. After NAFTAwent into effect, this measure ofwage inequality stopped increas-ing and turned gradually down-ward from 1997–2007, althoughas of 2007 it remained 34 percentabove its 1987 level. While thereare probably several causes ofthis reversal, the leading explana-tion is an increase in the relative

- 100

- 75

- 50

- 25

0

25

50

75

100

1993 1995 1997 1999 2001 2003 2005 2007Source: INEGI.

MEXICO S TRADE BALANCE: TOTAL AND WITH THE US, ASIA AND ALL NON-US COUNTRIES

1993–2008Billion US dollars

US

Asia

Total

All non-UScountries

,Figure 3

1.5

2.0

2.5

3.0

3.5

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Sources: INEGI; authors’ calculations. (The old survey, based on 129 classes of economic activity, and the new one, based on 205 classes, were spliced together in 1994, which was the one year of overlap.)

RATIO OF SALARIES OF EMPLOYEES TO WAGES OF PRODUCTION WORKERS IN THE NON-MAQUILADORA MANUFATURING INDUSTRIES OF

MEXICORatio of salaries to wages

Figure 4

15 See Esquivel and Rodríguez-López(2003) and Verhoogen (2008). Feenstra(2006) argues that trade liberalization‘selects’ for more efficient industrial firmsand plants, resulting in increases in aver-age productivity and decreases in the useof less-skilled labor as less efficient firmsand plants are eliminated and more effi-cient ones expand.

Page 26: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

supply of more-skilled labor dueto the rising levels of educationof the Mexican labor force.16

The changes in wage inequality inMexico also have important re-gional and gender dimensions.17

Census data reveal that regionalinequality between workers in thenorthern and southern Mexicanstates increased between 1990 and2000. For the more recent period,studies have found that thedecreases in the skill gap in thelate 1990s and early 2000s wereconcentrated in the northern bor-der states, which have the highestdegree of ‘globalization’ according to various indica-tors of exports and FDI. Furthermore, the decrease inthe skill gap in the last decade occurred almost exclu-sively among women workers in those states. In the restof the country, where the effects of imports are likely todominate the effects of exports and where there hasbeen relatively less FDI, less-skilled workers (of eithergender) do not appear to have benefited as much fromtrade liberalization either pre- or post-NAFTA.

Thus, it is difficult to generalize about the effects oftrade liberalization or NAFTA on Mexico’s wagestructure, as there were many effects that went in dif-ferent directions for different groups of workers andregions of the country at different times (and not allof the distributional changes were caused by tradepolicy). If anything, the evidence seems more clear-cut that the initial liberalization contributed to therise in wage inequality from 1987–1997, whileNAFTA’s effects are more muted and mixed. This isnot surprising, since the earlier liberalization involveda more drastic opening of Mexico’s economy com-pared to NAFTA.18

However, there are other dimensions of income distri-bution that can be affected by trade policy beyond therelative wages of more- and less-skilled workers,which have received perhaps disproportionate atten-

tion from economists on both sides of the border.What Mexico hoped for when it opened its economyand joined NAFTA was not merely a reduction ininequality among different groups of workers, butmore importantly a significant increase in the averagewage level for all Mexican workers. This, in turn,would have contributed to a rising standard of livingfor most citizens and a diminution of outward migra-tion. This simply has not come to pass, especially inthe tradable goods industries that are most impactedby trade.

Figure 5 shows an index of Mexico’s average realcompensation per person in manufacturing since1980.19 Evidently, this index has followed the cycles inthe Mexican economy, as real compensation collapsedduring the debt crisis of the early 1980s, partiallyrecovered in 1988–1994, collapsed again following thepeso crisis in 1995–1996, and recovered once more inabout 1998–2003. However, average real compensa-tion stagnated in the last five years shown(2003–2008), and at the end of this period was barelyback to its pre-crisis level of 1994. In the long run,average real labor compensation in Mexican manufac-turing has not increased since the debt crisis of theearly 1980s. Since average US wages rose during thisperiod, the wage gap with the United States increasedrather than decreased.

In hindsight, the expectations of significant overallwage gains for Mexican workers as a result of tradeliberalization alone were surely unrealistic. The pre-diction that Mexican workers in general – and less-skilled workers in particular – would benefit from

CESifo Forum 4/2010 24

Focus

16 See Esquivel, Lustig and Scott (2010). In addition, López-Córdova(2004) shows that average Mexican tariffs remained higher on goodsthat were more intensive in less-skilled labor after trade liberalizationand NAFTA. Also, Robertson (2007) cites the rising proportion ofmaquiladora employment in total manufacturing employment asindicating an increase in the relative demand for less-skilled labor.17 This paragraph draws on the following sources: Hanson (2004),Borraz and López-Córdova (2007), and Chiquiar (2008).18 According to USITC (1991), the average tariffs in effect at thetime NAFTA was adopted were about 3.4 percent for US importsfrom Mexico and 10 percent for Mexican imports from the UnitedStates.

0

20

40

60

80

100

120

140

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: Banco de México. Data wer seasonaly adjusted by the authors.

1993 = 100 NAFTA

REAL COMPENSATION PER WORKER IN MEXICO S NON-MAQUILADORA MANUFATURING INDUSTRIES

,Figure 5

19 Compensation (‘remuneraciones’ in Spanish) includes fringe bene-fits in addition to wages or salaries.

Page 27: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201025

Focus

trade liberalization hinged on the assumption that

Mexico had a relative abundance of (less-skilled)

labor compared with its trading partners. Although

this is true in regional terms, i.e. in comparison with

Canada and the United States, it is not true in global

terms, i.e. in a world economy that includes the much

more labor-abundant countries of South and East

Asia. Mexico is close to the world average in terms of

labor abundance, in-between highly labor-abundant

countries like China and India on the one side, and

relatively labor-scarce countries like the United States

and Canada on the other (Blecker 2010). Similarly,

although Mexico is the low-wage country in North

America, it is a medium-wage country globally

(Leamer 1998). Thus, Mexico does not have a global

advantage in labor costs and should not have been

expected to reap large gains in wages from opening up

to trade, except in those sectors where the country can

parlay its geographic proximity to the US market into

special competitive advantages.

Why Mexico is not converging?

In addition to what has already been mentioned, there

are a number of domestic factors that explain why

Mexico is not converging to US levels in terms of

income per capita, income per worker, or average

wages. Among other aspects, we can mention the fol-

lowing: (1) badly implemented economic reforms,

which instead of promoting economic growth have

actually been a drag on it; (2) lack of other important

economic reforms in areas such as rule of law, compe-

tition, financial sector, education, infrastructure, etc.;

(3) lack of a domestic engine that could complement

the external one (mainly represented by the US indus-

trial sector and consumer market); and (4) restrictive

macroeconomic policies. Let us review each of these

aspects in more detail.

Badly implemented economic reforms

In the second half of the 1980s and the early 1990s,

Mexico undertook a series of economic reforms

(trade opening, financial reform, and privatization of

banks, highways, etc.) that were supposed to radically

transform the semi-closed, inward-looking Mexican

economy into a more modern and export-oriented

one. Some of these reforms, however, were badly

implemented and led to disastrous outcomes that in

some cases were the opposite of what the policies were

supposed to achieve (Esquivel and Hernández-Trillo

2009). The privatization of banks, for example, was

done without having a proper institutional and regu-latory framework, which then led to an unsustainablecredit boom that exacerbated the costs associatedwith the currency crisis of December 1994 (the so-called Tequila crisis). Something similar happenedwith the privatized highways, which were subsequent-ly bailed-out by the Mexican government at anextremely high cost. Other privatizations, such as thatof the state telephone company Telmex, only replaceda public monopoly with a private one, which has sincethen extracted huge rents from a captive and mostlyuncontested domestic market (Del Villar 2009).

Lack of other important economic reforms

The negative outcomes of some of the previous eco-nomic reforms, together with political gridlock in thenewly multi-party Congress (since 1997), have led to areform paralysis in the country. In fact, since the mid-1990s there have been no new important economicreforms in Mexico, despite the fact that everyoneacknowledges the importance of undertaking certainchanges in the economy. Of course, some of thesereforms are highly controversial and there wouldhardly be a consensus on some of them, as in the caseof fiscal or labor reform, where the approaches andproposed solutions of different political parties arecompletely different. However, there are certainreforms that could be easily approved and implement-ed and that would not engender ideological con-frontation among the different political parties,although they would undoubtedly affect some specialinterests groups. So far, these groups have been suc-cessful in blocking or even avoiding discussion ofthese reforms, which include the rule of law, competi-tion policy, and financial regulation.

Lack of a domestic engine

One thing that has definitely changed since NAFTA isthe increasing correlation of Mexican and US busi-ness cycles, presumably reflecting greater sensitivity ofthe Mexican economy to short-run fluctuations in theUS economy. Several studies using a variety of statis-tical methodologies have found large and significantincreases in the ‘synchronization’ of Mexican outputgrowth and industrial production with the corre-sponding US variables since NAFTA.20 Figure 6 con-firms graphically that Mexican GDP growth has beenhighly correlated with US GDP growth since 1994,except for 1995 when Mexico suffered a steep reces-

20 See, for example, Blecker (2009) and the references cited therein.

Page 28: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

sion during the peso crisis, while no significant corre-lation can be seen in the prior years. The large impactof US growth on Mexico benefited the latter duringthe United States’ boom of the late 1990s, but had aless favorable impact during the slower-growth yearsof the early 2000s and especially in the financial crisisand global recession of 2008–2009.

The strong correlation between the Mexican and USeconomies is partly behind the remarkably steadyMexico-US ratios of income per capita and income perworker shown in Figure 1. Indeed, the fact that botheconomies have been growing at similar rates since1996 (as shown in Figure 6) explains why those ratioslook practically unchanged since NAFTA’s enactment.Of course, such a strong correlation can only beexplained by the lack of a domestic engine in Mexico.This result is rather surprising considering that Mexicois one of the largest economies in the world and pre-sumably would have a relatively large domestic market.However, Mexico’s transformation into an outward-looking, export-oriented economy probably went toofar and may have reached the point where the domesticmarket becomes almost irrelevant, thereby aggravatingthe country’s external vulnerability especially to eco-nomic conditions in the US market.

Macroeconomic policy restrictions

In addition to the reforms already described, there havebeen two other important reforms in the conduct ofmacroeconomic policy in Mexico in recent years: on theone hand, the Central Bank is now independent and hasprice stability as its single objective; on the other hand,fiscal policy is conducted according to a highly pro-cyclical rule, which mandates a zero deficit regardless of

the state of the business cycle. Thiscombination of policies, togetherwith the strong correlation of theMexican and US economies,implies a straitjacket for the con-duct of macroeconomic policythat severely limits the ability ofMexican policy makers to respondto external shocks in a counter-cyclical manner (Esquivel 2010).This means that the Mexicaneconomy absorbs all the externalshocks and has no ability to pur-sue independent stimulus policies.Furthermore, the institutionaldesign of macroeconomic policyin Mexico may even exacerbate

negative shocks by inducing fiscal, monetary, andexchange rate policies that end up increasing exchangerate and output volatility. The profound economicimpact of the financial crisis of 2008–2009 on theMexican economy is a case in point.

New opportunities and US interests

After the eventual recovery from the financial crisis andglobal recession of 2008–2009, Mexico and the UnitedStates are likely to enjoy certain opportunities forrenewing their economic cooperation in their mutualinterest. One positive development on the Mexican sideis that the crisis left the peso at a more competitiveexchange rate than it had been at for more than adecade. The peso depreciated from about 10 per dollarin August 2008 to 15 in March 2009, before recuperat-ing to 13 in October 2009. This represents a multilater-al real depreciation close to 20 percent since the begin-ning of the crisis. If the peso is allowed to remain atsuch a competitive level going forward, Mexican indus-tries could get a leg up in attracting FDI and exportingto the US market and elsewhere.

Just before the financial crisis worsened in September2008, the business press was noting a trend toward thereturn of some manufacturing production from Asiato both the United States and Mexico, as a result ofthe high energy prices and transportation costs thathad emerged at that time coupled with the then-lowervalue of the dollar and concerns over quality controlin China.21 The financial crisis and recession tem-

CESifo Forum 4/2010 26

Focus

- 8

- 6

- 4

- 2

0

2

4

6

8

10

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: IMF, World Economoc Outlook Database.

ANNUAL GROTH RATES OF REAL GDP, US AND MEXICO1970–2009

%

Mexico

NAFTA

US

Figure 6

21 Regarding the impact of exchange rates and transportation costs,see Mui (2008), and Rubin and Tal (2008). In regard to quality con-cerns about Chinese imports, see Engardio and Smith (2009).

Page 29: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201027

Focus

porarily interrupted this process, as energy prices

tanked, transportation costs fell, and the dollar tem-

porarily recovered (not only against the peso, but

against most currencies) in the fall and winter of

2008–2009. However, as the global economy began to

revive in the second half of 2009, energy and com-

modity prices started to recover and the dollar

resumed its previous downward course against the

major currencies such as the euro. If the dollar and

peso both stay low and transportation costs again rise

when global demand recovers, the potential for a

revival of both Mexican and US manufacturing is

enormous.

Press reports also indicate that existing foreign

investment in Mexico has been remarkably resilient

in spite of the increased violence resulting from the

government’s crackdown on narcotrafficking

(Engardio and Smith 2009); success in the latter

effort could help the country attract yet more FDI

inflows. Furthermore, although both the US and

Mexican automobile industries took a big hit in the

crisis, as the auto companies begin to focus on small-

er and more fuel-efficient cars for the US market,

there is significant potential for a recovery of region-

al trade in automobiles and auto parts. One sign of

this potential is the (pre-crisis) announcement by

Ford Motors that it would produce a new (low-cost,

fuel-efficient) Fiesta model at its plant in Toluca,

Mexico (Roig-Franzia 2008).

The Ford example reminds us of why US-Mexican

trade relations can be fraught with conflict, since the

jobs that will be supported at the Toluca plant are

jobs that will not be found in Detroit or elsewhere in

the United States. Indeed, the likelihood of US auto

companies increasing their outsourcing was a major

point of controversy in regard to the government

bailout of the US automakers in early 2009. Never-

theless, there are many reasons why expanded trade

with Mexico and efforts to promote Mexican conver-

gence are in the US interest.

First, trade with Mexico is more of a two-way street

for the United States than trade with most Asian

countries. Although the United States has a large

overall trade deficit, its deficit with Mexico is rela-

tively smaller in proportional terms. The average

ratio of US imports to US exports in 2008 was

1.6:1; this ratio was only 1.4:1 for US trade with

Mexico but 4.7:1 for US trade with China. Thus,

even though some Mexican production displaces

some US jobs, Mexico is a better customer for US

exports than most other countries, and hence trade

with Mexico also supports relatively more US jobs.

Hence, a growing Mexican economy would be an

opportunity for, not a threat to, the United States.

Second, the primary economic driver of migration

from Mexico to the United States is the persistently

large wage gap between the two countries, i.e. the lack

of convergence in wages. Hence, policies that could

foster convergence between the two countries via

increased wages in Mexico are the one and only thing

that can, in the long run, stem the tide of Mexican

workers seeking to cross the US border. Instead of

building walls, regional efforts to promote Mexican

growth and convergence would be the best way to

reduce migration pressures.

Third, there are special opportunities for mutual

gains from US-Mexican cooperation in the areas of

health care and elder care services. Given the aging of

the US population and the high and rising costs of

health and elder care in the United States, it would

make sense to allow US Medicare benefits and pri-

vate insurance payments to flow to Mexican

providers of medical care and elder services (e.g.

assisted living or nursing homes), who can provide

those services at significantly lower cost. In fact,

some US senior citizens are already taking advantage

of the lower cost of retiring and seeking medical

treatments in Mexico, but their numbers could be

vastly expanded if Medicare and insurance benefits

were allowed to be spent there (subject, of course, to

adequate quality controls). This could provide enor-

mous numbers of jobs for Mexicans not only in

health and elder care directly, but also in various sup-

plier industries. Given that the manufacturing sector

does not seem capable of supplying adequate num-

bers of jobs in Mexico, for the reasons discussed ear-

lier, Mexico needs to focus on other sectors, such as

services and construction, to solve its employment

problems. Since rising health care costs are threaten-

ing both the private and public sectors of the US

economy, both countries could reap enormous gains

from such an arrangement.

This area of opportunity, however, will not be per-

manent since demographic complementarities

between Mexico and the United States will eventual-

ly disappear. To grasp an idea of how important the

Mexico-US demographic complementarities are,

Figures 7 and 8 show the age structure and the old-

age dependency ratio, respectively, for both countries.

The age structure is shown for 2005, whereas the pro-

Page 30: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

jected old-age dependency ratio is shown for the2005–2050 period. This ratio is defined as the numberof people aged 65 and over as a percentage of theproductive segment of the population, which isdefined as people aged 15 to 64. The figure clearlyshows two important elements: first, the old-agedependency ratio in the United States is currentlytwice as high as it is in Mexico and it will be greaterthan the Mexican ratio at least for the next 40 years;second, the gap in old-age dependency ratios willsteadily increase until the mid 2020s, when the gapwill slowly start to decline. This means that the nextten or fifteen years will be the best time for exploitingthe demographic complementarities between Mexicoand the United States. For that reason, this area ofopportunity is one that needs to be explored immedi-ately in order to reap the largest possible benefits forboth countries.

Conclusions

The decision to convert NorthAmerica into a free trade areawith the adoption of NAFTAconcealed a deeper clash ofvisions over what kind of eco-nomic integration was intended.On the one hand, some econo-mists supported it reluctantlybecause of its preferential nature.These economists wanted aNAFTA that would keep NorthAmerica wide open to trade withother global regions and that, ineffect, would be little but a waystation on the road to multilater-al trade liberalization. On theother hand, some advocates of‘industrial policy’ sought aNAFTA that would function as atrue trading bloc, transformingNorth America into a more inter-nally integrated and externallycompetitive region. The industri-al policy advocates were con-cerned mostly about competitionfrom Japan, the four Asian tigers,and the European Union (EU) inthe early 1990s; China was notyet on their radar screens.

In reality, NAFTA – in spite of itsmany exceptions to pure free trade– ended up functioning more like

a globally open regional market than a self-containedtrading bloc, and this had a profound impact on whatthe agreement did and did not accomplish for theMexican and US economies in the long run. NAFTAwas neither the panacea promised by the Mexican gov-ernment nor the disaster predicted by some US oppo-nents. Although the agreement did have a significantimpact on trade and investment flows, it had at most amodest impact on the variables that matter most, suchas employment, income distribution and growth. Thebiggest problem is not what NAFTA did, but what itdidn’t do, namely, to foster a regional integrationprocess that could have lifted up the Mexican economyand produced a convergence in Mexican per capitaincome or average wages toward US levels.

The point is not that NAFTA should have been aneconomic ‘fortress’ defended by high protectionist

CESifo Forum 4/2010 28

Focus

6 4 2 0 2 4 6

0-45-9

10-1415-1920-2425-2930-3435-3940-4445-4950-5455-5960-6465-6970-7475-7980-8485-8990-94

95-100

Men

15 10 5 0 5 10 15

0-45-9

10-1415-1920-2425-2930-3435-3940-4445-4950-5455-5960-6465-6970-7475-7980-8485-8990-94

95-100

WomanMexico

MEXICO AND US POPULATION PYRAMID 2005United States

Million MillionSources: Comisión Nacional de Población for Mexico; US Census Bureau for the Unted States.

Figure 7

- 10

0

10

20

30

40

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

OLD-AGE DEPENDENCY RATIOS IN MEXICO AND THE US2005–2050

%

Mexico

US

Sources: Comisión Nacional de Población for Mexico; US Census Bureau for the Unted States; authors' calculations.

US - Mexico Gap

Figure 8

Page 31: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201029

Focus

barriers. Rather, the problem was that neitherMexico nor the United States ever adopted the com-plementary policies that could have promoted amore successful regional integration effort. Thesepolicies would have included promulgating adequateeducation and industrial policies, making the neces-sary infrastructure investments, and maintainingcompetitive exchange rates. Furthermore, theNAFTA countries did not adopt policies to pro-mote convergence of the less developed regions ofthe sort used in the EU, such as its regional andsocial cohesion funds (Pastor 2001). Although theUnited States extended some additional TradeAdjustment Assistance for US workers displaced bytrade with Canada or Mexico, overall the NAFTAcountries did not implement adequate social safetynets for groups adversely impacted by the agree-ment’s adjustment costs. Mexico eventually adoptedcertain redistributive policies, i.e. the Procampo andProgresa/Oportunidades programs, but these werepoorly designed (in the case of Procampo) and cametoo late or on too small a scale to assist during theinitial liberalization of trade or the first few years ofNAFTA.

Although NAFTA did promote increasing regionalintegration in the late 1990s, in the early 2000s thistrend was partially reversed as the lower trade barrierswithin North America were overwhelmed by otherdevelopments, including the lowering of global tradebarriers under the WTO, the tightening of US borderrestrictions, and the emergence of China as an eco-nomic powerhouse. In effect, the vision of NAFTA asa globally open trading region rather than a morecompetitive trade bloc won out, but the goal of pro-moting economic convergence of Mexico to US andCanadian levels of per capita income lost out. Thechallenge for the US and Mexican governments goingforward is to see if they can find a way to rejuvenatethe process of regional integration that can movetoward that goal while serving the mutual interests ofthe US and Mexican economies.

References

Blecker, R.A. (2009), “External Shocks, Structural Change, andEconomic Growth in Mexico, 1979-2007”, World Development 37,1274–1284.

Bleker, R.A. (2010), “Comercio, Empleo y Distribución: Efectos de laIntegración Regional y Global”, in: Lustig, N., A. Y. Naude and A. C. Sabido (eds.), México 2010: Volumen Economía, Mexico City: El Colegio de México, forthcoming.

Borraz, F. and J.E. López-Córdova (2007), “Has Globali-zation Deepened Income Inequality in Mexico?”, Global Economy Journal 7/1, Article 6,http://www.bepress.com/gej/vol7/iss1/6.

Chiquiar, D. (2008), “Globalization, Regional Wage Differentials andthe Stolper-Samuelson Theorem: Evidence from Mexico”, Journal ofInternational Economics 74, 70–93.

Cohen, S.D., R.A. Blecker and P.D. Whitney (2003), Fundamentals ofU.S. Foreign Trade Policy, 2nd edition, Boulder: Westview.

Del Villar, R. (2009), “Competition and Equity inTelecommunications”, in: Walton, M. and S. Levy (eds.), No Growthwithout Equity, Washington DC: World Bank/Palgrave MacMillan,321–369.

Engardio, P. and G. Smith (2009), “Business Is Standing Its Ground”,Business Week, 20 April, 34–39.

Esquivel, G. (2010), “De la Inestabilidad Macroeconómica alEstancamiento Estabilizador: El Papel del Diseño y Conducción de laPolítica Económica en México”, in: Lustig, N., A. Y. Naude and A. C. Sabido (eds.), México 2010: Volumen Economía, Mexico City:El Colegio de México, forthcoming.

Esquivel, G. and J.A. Rodríguez-López (2003). “Technology, Trade,and Wage Inequality in Mexico before and after NAFTA”, Journal ofDevelopment Economics 72, 543–565.

Esquivel, G. and F. Hernández-Trillo (2009), “How Can ReformsHelp Deliver Growth in Mexico?”, in: Rojas, L. (ed.), Growing Painsin Latin America, Washington DC: Center for Global Development,192–235.

Esquivel, G., N. Lustig and J. Scott (2010), “Mexico: A Decade ofFalling Inequality. Market Forces or State Action?”, in: López-Calva,L. F. and N. Lustig (eds.), Declining Inequality in Latin America. A Decade of Progress?, Washington DC: Brookings Institution Press,forthcoming.

Feenstra, R.C. (2006), “New Evidence on the Gains from Trade”, Reviewof World Economics (Weltwirtschaftliches Archiv) 142, 617–641.

Feenstra, R.C., and H.L. Kee (2009), “Trade liberalization andExport Variety: A Comparison of Mexico and China”, in:Ledermann, D. et al. (eds.), China’s and India’s Challenge to LatinAmerica: Opportunity or Threat?, Washington DC: World Bank,245–263.

Galindo, L.M. and J. Ros (2008), “Alternatives to Inflation Targetingin Mexico”, International Review of Applied Economics 22, 201–214.

Gallagher, K.P., J.C. Moreno-Brid and R. Porzecanski (2008), “TheDynamism of Mexican Exports: Lost in (Chinese) Translation?”,World Development 36, 1365–1380.

Gallagher, K.P. and L. Zarsky (2007), The Enclave Economy: ForeignInvestment and Sustainable Development in Mexico’s Silicon Valley,Cambridge, MA: MIT Press.

Haber, S., H.S. Klein, N. Maurer and K. J. Middlebrook (2008),Mexico since 1980, New York: Cambridge University Press.

Hanson, G. (2004), “What Has Happened to Wages in Mexico sinceNAFTA? Implications for Hemispheric Free Trade”, in:Estevadeordal, A. et al. (eds.), Integrating the Americas: FTAA andBeyond, Cambridge, MA: Harvard University Press, 505–537.

Hanson, G. (2006), “Illegal Migration from Mexico to the UnitedStates”, Journal of Economic Literature 44, 869–924.

Hanson, G. and R. Robertson (2009), “China and the RecentEvolution of Latin America’s Manufacturing Exports”,Ledermann, D. et al. (eds.), China’s and India’s Challenge to LatinAmerica: Opportunity or Threat?, Washington DC: World Bank,145–178.

Hufbauer, G.C. and J.J. Schott (1992), North American Free Trade:Issues and Recommendations, Washington DC: Institute forInternational Economics.

Hufbauer, G.C. and J.J. Schott (2005), NAFTA Revisited:Achievements and Challenges. Washington, DC: Institute forInternational Economics.

Leamer, E.E. (1998), “In Search of Stolper-Samuelson Linkagesbetween International Trade and Lower Wages”, in: Collins,S. M. (ed.), Imports, Exports, and the American Worker, WashingtonDC: Brookings Institution, 141–214.

Lederman, D., W.F. Mahoney and L. Servén (2005), Lessons fromNAFTA for Latin America and the Caribbean, Washington DC: WorldBank.

López A G. (2006), Mexico: Two Decades of the Evolution of Educationand Inequality, World Bank Policy Research Working Paper 3919.

Page 32: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

López-Córdova, E. (2004), Economic Integration and ManufacturingPerformance in Mexico: Is Chinese Competition to Blame?, WorkingPaper 23, Latin America/Caribbean and Asia/Pacific Economics andBusiness Association (LAEBA).

Lustig, N. (1998), Mexico: The Remaking of an Economy, 2nd Edi-tion, Washington DC: Brookings Institution.

Moreno-Brid, J.C., J. Santamaría and J. C. Rivas Valdivia (2005),“Industrialization and Economic Growth in Mexico after NAFTA:The Road Travelled”, Development and Change 36, 1095–1119.

Mui, Y.Q. (2008), “Ikea Helps a Town Put It Together: Manu-facturing Jobs Come Back to Southern Va”, Washington Post, 31 May.

Pastor, R.A. (2001), Toward a North American Community: Lessonsfrom the Old World for the New, Washington DC: Institute forInternational Economics.

Revenga, A.L. and C.E. Montenegro (1998), “North AmericanIntegration and Factor Price Equalization: Is There Evidence ofWage Convergence between Mexico and the United States?”, in:Collins, S. M. (ed.), Imports, Exports, and the American Worker,Washington DC: Brookings Institution, 305–347.

Robertson, R. (2007), “Trade and Wages: Two Puzzles from Mexico”,World Economy 30, 1378–1398.

Roig-Franzia, M. (2008), “Ford’s ‘Global Car’ to Roll Out in Mexico:Small, Efficient Auto Designed to Be Sold Anywhere”, WashingtonPost, 31 May.

Rubin, J. and B. Tal, (2008), “Will Soaring Transport Costs ReverseGlobalization?”, StrategEcon, CIBC World Markets, 27 May, 4–7,http://research.cibcwm.com/economic_public/download/smay08.pdf.

Ruiz-Nápoles, P. (2004), “Exports, Growth, and Employment inMexico, 1978-2000”, Journal of Post Keynesian Economics 27,105–124.

Scott, R.E., C. Salas and B. Campbell (2006), Revisiting NAFTA: StillNot Working for North America’s Workers, EPI Briefing Paper 173,Economic Policy Institute, Washington DC.

Studer, I. and C. Wise (2007, eds.), Requiem or Revival? The Promiseof North American Integration, Washington DC: BrookingsInstitution.

US Council of Economic Advisers (2009), Economic Report of thePresident 2009, Washington DC: Government Printing Office,www.gpoaccess.gov/eop/download.html.

US International Trade Commission (USITC, 1991), The LikelyImpact on the United States of a Free Trade Agreement with Mexico,USITC Publication 2353, Washington DC: USITC.

Verhoogen, E.A. (2008), “Trade, Quality Upgrading, and WageInequality in the Mexican Manufacturing Sector”, Quarterly Journalof Economics 123, 489–530.

CESifo Forum 4/2010 30

Focus

Page 33: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201031

Focus

MEASURING THE ECONOMIC

EFFECTS OF NAFTA ON

MEXICO

DOMINICK SALVATORE*

Introduction

The economic effects of NAFTA on Mexico havebeen discussed and measured, for the most part, interms of its effect on employment on both sides of theborder and by the increase in Mexico-US trade andinvestments before and after NAFTA. Measured inthis way, some economists predicted that NAFTAwould create hundred of thousand of new jobs onboth sides of the border, reduce wage inequalitiesbetween the United States and Mexico, and sharplyreduce the migration of Mexicans to the UnitedStates (see, for example, Hufbauer and Schott 1992).Others, such as Ross Perot (the third party candidatein the 1992 US Presidential election), believed insteadthat the United States would lose thousand of jobs toMexico as US firms migrated south attracted by muchlower wages and fewer labor and environmental regu-lations (the ‘giant sucking sound’). Of course, bothpredictions were wrong, but what is more important isthat measuring the effect of NAFTA based on itseffect on employment and comparing trade beforeand after the Agreement is incorrect.

More reasonable economists attempted to measurethe effects of NAFTA by comparing Mexican growthbefore NAFTA and with NAFTA. This also is wrongbecause, as we know, growth is affected by many otherfactors, independently of NAFTA. For example,Mexico faced a serious financial and economic crisisin 19941995 (just when NAFTA took effect), theUnited States faced recession in 2001 and slow growthin 2002, and China joined the WTO in December2001, thus becoming a more powerful competitor ofMexico in the United States and on world markets(and also leading to the diversion of some foreign

direct investments from Mexico to China – see also

Salvatore 2010a). Thus, measuring the economic

effects of NAFTA on Mexico based on the net num-

ber of jobs created or destroyed, or by comparing

Mexican growth before and after NAFTA, is not

appropriate.

Measuring the economic effects of free trade areasand NAFTA

Until Jacob Viner wrote his classic work The Customs

Union Issue in 1953, economists believed that a free

trade area (FTA), by removing trade restrictions

among member states, increased specialization in pro-

duction and invariably benefited the member coun-

tries and it also had positive spillover effects on the

rest of the world. Viner, however, showed that this was

not necessarily the case. Member nations and the rest

of the world would benefit only if the FTA created,

rather than diverted, trade. This is an application of

the theory of the second best, which postulates that if

all the conditions for first best or maximum social

welfare (free trade) are not satisfied, trying to satisfy

as many of the conditions as possible (partial trade

liberalization) is not necessarily or usually second

best. Lipsey (1961) then specified the conditions

under which a FTA was more likely to be trade creat-

ing and thus welfare enhancing.

Meade (1955) extended Viner’s analysis showing that

by considering not only the production effects of FTA

(as Viner did) but also the consumption effects of a

FTA, then even a trade-diverting FTA could improve

members’ and world’s welfare. Meade pointed out

that the smaller the relative inefficiency of FTA mem-

bers in relation to non-members, the greater was the

probability that even a trade-diverting FTA or cus-

toms union could lead to net benefits to members and

non-member nations. Although important, this

method of measuring the economic effects of a FTA

concentrates on the static effects of economic integra-

tion without considering its more significant dynamic

effects, such as the increased competition, economies

of scale, stimulus to investment, and the generally bet-

ter utilization of economic resources. * Fordham University, New York. This paper is a revision andupdate of Salvatore (2007).

Page 34: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

According to theory, therefore, the appropriatemethod of measuring the effects of a FTA, such asNAFTA, is by the increased efficiency and produc-tivity resulting from specialization in production,trade, investments, and competition. This increasedefficiency will certainly affect wages, employmentand growth. But welfare can increase in a membernation even if the FTA creates few or no jobs, aslong as it increases efficiency and productivity in thenation. Such an increase in efficiency and productiv-ity will stimulate growth in member nations but sincegrowth also depends on other crucial concomitantfactors, it is impossible to identify the specific effectsof a FTA by comparing its growth before and afterits formation. But this is exactly how the effects ofFTAs, in general, and of NAFTA, in particular, havebeen mostly measured – that is, by its effect onemployment and on growth before and after the for-mation of the FTA (see, for example, Hufbauer andSchott 1992, 2005 and 2008; Kose, Meredith andTowe 2004).

The correct way to measure the effects of a FTA onmember nations, instead, is by counterfactual simula-tion of its effect on intra-FTA trade and growth.That is, by how much intra-FTA trade and growth ishigher with the FTA as compared with the situationwithout the FTA. Performing valid counterfactualsimulations are fraught with difficulties, however. Ageneral equilibrium model of trade and growthwould have to be constructed, the model would haveto be validated by in-sample dynamic simulation, andthen used for counterfactual simulation. In our case,this would involve estimating how high trade and

growth would have been among the FTA memberswithout the FTA.

I will begin, instead, with a more down-to-earth andless elegant but still legitimate method of estimatingthe economic effects of NAFTA on Mexico by com-paring (1) the growth of intra-Mexico-US trade, onthe one hand, to the growth of total Mexican trade,on the other, during the first dozen years (i.e. until2005) of NAFTA’s operation and also until 2008(when the NAFTA accord became fully operational)and (2) by comparing the flow foreign direct invest-ment (FDI) from the United States to Mexico, to totalFDI to Mexico, over the same periods. I will then pre-sent the results of a counterfactual simulation of theeffect of NAFTA on trade, FDI, growth, inflation,and other economic and financial variables.

The effects of NAFTA on Mexican trade

Table 1 shows the level and growth of Mexican exportsto the United States as well as total Mexican exports tothe rest of the world from 1984–1993 (i.e. during thedecade before the formation of NAFTA) and duringthe first dozen years since the creation of NAFTA (i.e.until 2005) and also until 2008. The table shows thatfrom 1984–1993, total Mexican exports grew fromUSD 29.4 billion in 1984 to USD 51.9 billion in 1993,or at an average yearly rate of 5.5 percent. On the otherhand, Mexican exports to the United States grew fromUSD 18.1 billion in 1984 to USD 40.4 billion in 1993,or at a yearly average rate of 7.6 percent. Thus, from1984–1993 (i.e. in the decade before NAFTA), Mexican

CESifo Forum 4/2010 32

Focus

Table 1

Mexico’s exports: 1984–1993, 1994–2005 and 1994–2008

(billion US dollars)

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Average

growth

1984–1993

Total 29.4 27.2 22.0 28.0 30.8 35.3 41.0 42.9 46.2 51.9 5.5%

To US 18.1 19.1 17.7 20.3 23.3 27.1 30.5 31.5 35.6 40.4 7.6%

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Total 60.9 79.5 96.0 110.4 117.5 136.4 166.1 158.8 161.0 164.8

To US 50.1 62.8 75.1 86.7 95.4 110.6 137.0 132.6 136.1 139.8

Year 2004 2005 2006 2007 2008

Average

growth

1994–2005

Average

growth

1994–2008

Total 188.0 214.2 249.9 271.9 291.3 9.3% 8.7%

To US 158.3 173.5 202.0 214.8 220.3 9.2% 8.4%

Sources: WTO (2009); US Department of Commerce.

Page 35: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201033

Focus

exports to the United States grewmore rapidly that total Mexicanexports.

From Table 1, we see that in thedozen years of NAFTA’s opera-tion (i.e. until 2005) and alsountil 2008, the total exports ofMexico increased at about thesame rate as Mexican exports tothe United States. We wouldhave expected, instead, thatintra-FTA trade would growfaster than extra-FTA tradebecause of the elimination oftrade barriers among membercountries but not with respect tononmembers. Actually, the in-crease in Mexican exports to theUnited States jumped by an aver-age of 28.3 percent per year from1991–1993 in anticipation of NAFTA, as comparedwith an average increase of 21.0 percent for totalMexican exports over the same period. But Mexicanexports to the United States had been growing fasterthan the total exports of Mexico from 1984.

Similarly, Mexican exports to the United States grewmuch faster from 1994–2000 than from 2001–2005 orfrom 2001–2008, but over the entire 1994–2005 and1994–2008 Mexican exports to the United States grewat a slightly lower rate than total Mexican exports.Thus, NAFTA seems to have benefited Mexico (andthe United States) by leading to a more rapid expan-sion of trade in general for the three years precedingand for the seven years following the creation ofNAFTA as a result of the general liberalization oftrade (and the signaling of Mexico’s commitment tofurther liberalization and reform) rather than by amore rapid increase of Mexican-US trade, as such, inrelation to total Mexican trade.

The pattern of trade increase as a result of NAFTAalso seems somewhat different from that arising inthe European Union. Table 2 shows the value oftotal exports, intra-regional-trade-agreement(RTA) exports, and intra-RTA exports as a percent-age of the total RTA exports of the EuropeanUnion (EU) and NAFTA in 1990, 1995, 2000, 2005,and 2008. The table shows that the EU has a largerpercentage of intra-RTA trade than NAFTA, butintra-RTA increased only slightly for the EUbetween 1990 and 2005 and between 1990 and 2008,

while for NAFTA it increased significantly. The bigjump in intra-NAFTA trade, however, occurredduring the first five years of NAFTA.1 Intra-EUtrade also increased in the years immediately afterits creation (not shown in Table 2), but afterwardsintra-EU trade expanded at about the same rate astotal EU trade. Also note that there seems to havebeen no similar increase in intra-EU trade in antic-ipation of and immediately after the EU-expansionfrom 15 to 25 members in 2004 and from 25 to27 members in 2008.

The effects of NAFTA on the inflow of FDI toMexico

Another way by which a FTA can benefit a membernation is by encouraging an inflow of FDI, therebystimulating the growth of the nation. Table 3 com-pares the inflow of FDI to Mexico, in total and fromthe United States, before and since the creation ofNAFTA. The table shows that from 1984–1993, totalFDI into Mexico averaged USD 2.8 billion per year ascompared to USD 1.1 billion, or 39 percent of thetotal, coming from the United States. The big jump intotal FDI to Mexico during this period occurred in1991, perhaps in anticipation of NAFTA.

Table 2

Total and intra-EU and intra-NAFTA trade:

1990, 1995, 2000, 2005 and 2008

(billions US dollars and percentages)

NAFTA exports (billion US dollars)

Year Total Intra-NAFTA Intra-NAFTA as

percentage of total

1990 562 240 42.8

1995 857 394 46.0

2000 1,225 682 55.6

2005 1,478 824 55.8

2008 2,036 1,015 49.9

EU exports (billions US dollars)

Year Total Intra-EU Intra-EU as

percentage of total

1990 (EU15) 1,482 980 66.1

1995 (EU15) 1,937 1,295 66.9

2000 (EU15) 2,251 1,392 61.9

2000 (EU25) 2,437 2,523 67.5

2005 (EU25) 4,001 2,673 66.8

2008 (EU27) 5,898 3,974 67.4

Source: WTO (2009).

1 The sharp decline in Mexican intra-NAFTA exports as a percent-age of the total exports from 55.8 in 2005 to 49.9 in 2008 was theresult of the sharp reduction in US imports from Mexico as a resultthe economic crisis in the United States. In 2007, the correspondingpercentage was 51.6 (still lower that the value of 55.8 in 2005) as aresult of the approaching US crisis.

Page 36: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

Form 1994–2005, total FDI to Mexico averaged USD16.9 billion per year as compared with USD 5.7 bil-lion, or 34 percent of the total coming from theUnited States. The corresponding figures for1994–2008 are, respectively, 18.2, 6.4 and 35. The bigjump in FDI to Mexico in total and from the UnitedStates occurred in 1994 (the first year of NAFTA’soperation) and then again in 2001 (eight years afterthe start of NAFTA). As in the case of trade, there-fore, FDI to Mexico seemed to have increased as thegeneral result of the liberalization of foreign tradeand investments that accompanied the creation ofNAFTA and not as a direct and specific result ofNAFTA itself (since US FDI to Mexico did notincrease more rapidly that total FDI to Mexico dur-ing the NAFTA period).

NAFTA’s effects on Mexico’s growth

Table 4 shows the growth of real GDP in Mexicobefore and after the formation of NAFTA. Theexpectation was that by stimulating the flow of tradeand investments, a FTA would increase specializa-

tion in production and efficiency in general through-out the economy of a member nation, and thusspeed up its rate of growth. The specific effect ofNAFTA on Mexico’s growth, however, can only bemeasured by estimating what growth in Mexicowould have been without NAFTA and comparingthat with its actual growth (i.e. by counterfactualsimulation). As pointed out earlier, the reason forthis is that growth depends on many other factorsbesides NAFTA and comparing actual growthbefore and after NAFTA simply cannot identifyNAFTA’s contribution.

For example, Table 4 shows that the growth of realGDP averaged 2.5 percent per year in Mexico from1984–1993 (i.e. before NAFTA) and 2.8 percent fromper year from 1994–2005 (i.e. after the creation ofNAFTA) and 2.9 percent from 1994–2008. If weexclude the 1995 recession year in Mexico, yearlygrowth averaged 3.6 and 3.5 percent, respectively. Butwe cannot tell how much, if any, of the higherMexican growth since 1994 can be attributed toNAFTA. That can only be measured by counterfactu-al simulation.

CESifo Forum 4/2010 34

Focus

Table 3

Foreign direct investments inflows to Mexico:

1984–1993, 1994–2005 and 1994–2008

(billion US dollars)

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Average

1984–1993

Total 1.5 2.0 2.0 1.2 2.0 2.8 2.6 4.8 4.4 4.4 2.8

from US 0.3 0.5 – 0.1 0.3 0.6 1.4 1.9 2.3 1.3 2.4 1.1

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Total 11.0 9.5 9.2 12.8 12.7 13.9 18.1 29.8 23.6 16.6

from US 4.5 3.0 2.4 5.6 4.7 8.2 4.2 14.2 5.2 3.7

Year 2004 2005 2006 2007 2008

Average

1994–2005

Average

1994–2008

Total 23.8 22.3 19.8 27.3 23.2 16.9 18.2

from US 6.4 6.8 10.6 8.8 7.2 5.7 6.4

Sources: IMF (2010); US Department of Commerce.

Table 4

Growth of Real GDP: 1984–1993, 1994–2005 and 1994–2008 (%)

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993Average

1984–1993

GDP 3.5 2.5 – 3.6 1.8 1.3 4.2 5.1 4.2 3.6 1.9 2.5%

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

GDP 4.5 – 6.2 5.5 7.2 5.0 3.6 6.0 – 0.9 0.1 1.4

Year 2004 2005 2006 2007 2008

Average

1994–2005

Average

1994–2008

GDP 4.0 3.2 4.9 3.3 1.5 2.8 2.9

Source: OECD (2010).

Page 37: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201035

Focus

Table 5 shows long-run simulations results ofNAFTA’s impact on Mexico to the year 2005 andcompares these to the actual outcome using theUnited Nations LINK Model of the world economy.During the 1995–2005 period, Mexican real GDP wasestimated to grow at a rate of 5.2 percent per yearwith NAFTA, as compared with 3.8 percent withoutNAFTA. NAFTA was also expected to (1) reduce theMexican inflation rate from 14.5 percent to 9.7 per-cent per year and the short-term interest rate from18.3 percent to 13.0 percent, (2) increase the inflow offoreign direct investments (FDI) from USD 6.0 billionto USD 9.2 billion per year and the growth of exportsfrom 8.3 to 10.4 percent, and (3) raise the Mexicantrade deficit from USD 9.7 billion to USD 14.9 billionand net financial inflows from USD 10.6 billion toUSD 14.7 billion per year.

The actual results, as yearly averages from 1994–2005,were as follows: a growth rate of real GDP of 2.8 per-cent per year, a rate of inflation of 13.9 percent, ashort-term interest rate of 18.7 percent, an inflow ofFDI of USD 16.9 billion, a growth of exports of9.2 percent, a trade deficit of USD 7.7 billion, and netfinancial inflows of USD 16.8 billion. The actualresults for 1994–2008 were similar to those for1994–2005 (see the last column of Table 5).

Mexico did not realize more of the expected benefitsfrom NAFTA because of its deep economic crisis in1994–1995, the US recession in 2001 and slow

growth in 2002, and, more importantly, because ofweak economic institutions and inadequate structur-al reforms, which limited Mexico’s internationalcompetitiveness (Mexico ranked 47th out of58 economies evaluated according to the 2010 World

Competitiveness Report) in the face of increasedcompetition from China. If we removed from thedata 1995 (the recession year in Mexico) and also2001 and 2002 (the years of recession and slowgrowth in the United States, which reduced USimports from Mexico), the average annual growth ofreal GDP in Mexico would be 4.5 percent for1994–2005 and 4.1 for 1994–2008, which were hard-ly adequate to achieve a rapid increase in the stan-dard of living of the nation (and less than half ofChina’s growth rate over the same time period).

General effects of NAFTA on member nations

We now examine in more general terms the effect ofNAFTA on Mexico, the United States and Canada.As we have seen, NAFTA benefited Mexico by indi-rectly leading to greater export-led growth resultingfrom increased access to the huge US market and byincreasing inward foreign direct investments – all ofwhich increased production efficiency and competi-tion. Perhaps more significant than the change inthe total volume of trade was the change in the com-position of Mexican trade. As a result of verticalintegration, Mexican trade shifted much more

toward intra-industry and intra-firm trade with the UnitedStates and Canada. Mexico suf-fered a net loss of jobs and in-comes in agriculture, but theselosses were more than matchedby net increases in industry.With time, increasing employ-ment opportunities and risingwages in industry are expectedto reduce the pressure onMexicans to migrate to theUnited States. Mexico’s abilityto benefit from NAFTA hasbeen limited, however, by weakeconomic institutions and inad-equate structural reforms of theeconomy.

The implementation of NAFTAbenefited the United States byincreasing competition in prod-

Table 5

Simulation of NAFTA’s impact on the Mexican economy

(yearly averages: 1994–2005 and 1994–2008)

Estimates

with

NAFTA

Without

NAFTA Difference

Actual

results

1994–2005

Actual

results

1994–2008

Growth of

real GDP (%) 5.2 3.8 1.4 2.8 2.9

Inflation rate

(%) 9.7 14.5 – 4.8 13.9 12.0

Short-term

interest rate

(%) 13.0 18.3 – 5.3 18.7 16.5

Inflow of FDI

(bill. USD) 9.2 6.0 3.2 16.9 18.2

Growth of

exports (%) 10.4 8.3 2.1 9.2 8.4

Trade deficit

(bill. USD) 14.9 9.7 5.2 7.7 9.6

Net financial

inflows

(bill. USD) 14.7 10.6 4.1 16.8 16.2

Sources: Klein and Salvatore (1995); Hufbauer and Schott (2005);

IMF (2010); OECD (2010).

Page 38: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

uct and resource markets, as well as by lowering the

price of many commodities to US consumers.

Because the US economy is more than 15 times larger

than Mexico’s economy the US gains from NAFTA

as a proportion of its GDP were much smaller than

Mexico’s, however. Furthermore, with wages more

than six times higher in the United States than in

Mexico, NAFTA led to a loss of unskilled jobs, but an

increase of skilled jobs, for an overall net increase in

employment in the United States of between 90,000

and 160,000 (see Inter-American Development Bank

2002). A more recent study by Hufbauer and Schott

(2005), however, concluded that net gain in US jobs as

a result of NAFTA may have been much smaller (and

may even have resulted in a small net loss). Some

States (such as Alabama and Arkansas) suffered while

high-wage areas gained, but with a 15-year phase-in

period and about USD 3 billion assistance to dis-

placed workers, the harm to workers in low-income

areas in the United States was minimized.

Free trade access to Mexico allows US industries to

import labor-intensive components from Mexico

and keep other operations in the United States

rather than possibly losing all jobs in the industry

to low-wage countries. Some of the jobs that

Mexico gained during the years immediately pre-

ceding and following the creation of NAFTA did

not, in fact, come from the United States but from

other countries, such as Malaysia, where wages are

roughly equal to Mexico’s. As a condition for con-

gressional approval of NAFTA, the United States

also negotiated a series of supplemental agreements

with Mexico governing workplace and environmen-

tal standards (to prevent US firms from moving all

of their operations to Mexico to take advantage of

much more lax labor and environmental regula-

tions), as well as to protect some American indus-

tries against import surges that might threaten

them.

NAFTA did not directly affect Canada in a signifi-

cant way because Canada had already negotiated a

free trade agreement with the United States in 1988,

and so most of its economic effects on the two coun-

tries had already taken place by the time NAFTA

came into effect in 1994. Indeed, one could say that

the primary reason for Canada joining in the NAFTA

negotiations was to protect its trade interests with the

United States. Canada was and remains the largest

trade partner of the United States, Mexico was sec-

ond until 2006 when it was displaced by China, and

Japan is fourth.

Summary and conclusions

The economic effects of NAFTA on Mexico have

been discussed and measured mostly in terms of their

effect on employment on both sides of the border and

by the increase in Mexico-US trade and investments,

before and after NAFTA. These are not the appropri-

ate ways to measure the effects of a free trade area on

a member state. The theoretically correct way of mea-

suring the economic effects of a FTA on a member

nation is through its effects on trade, investments,

competition and efficiency. It is through these effects

that the growth and employment in the nation are

affected. To measure the direct effects of a FTA on

member nations requires using a counterfactual simu-

lation. That is, comparing trade, investments, compe-

tition, and efficiency in general and, through them,

their effect on growth and employment in the nation,

with and without the FTA.

In the case of NAFTA, the benefits flowing to Mexico

seem to have resulted more from the general liberal-

ization of trade and investments than directly from

NAFTA, as such. That is, the general liberalization of

trade and investments that accompanied NAFTA led

to a general increase in Mexican exports and inflows

of FDI, which increased specialization, competition,

productivity and efficiency in Mexico. But the

increase in total Mexican exports and FDI inflows

from the rest of the world was as large as or larger

than that from the United States. Furthermore, most

of the (indirect) benefits that Mexico received from

NAFTA occurred in the years immediately preceding

the creation of NAFTA rather than in the years soon

after its creation. Mexico was unable to capture more

of the potential benefits from NAFTA or for a longer

period of time because of the economic crisis that

afflicted Mexico in 1994–1995, the US recession in

2001 and slow growth in 2002, increased competition

from China, but, most importantly, because Mexico

failed to adequately restructure and liberalize its econ-

omy and improve the education and training of its

labor force.

The implementation of NAFTA benefited the

United States by increasing competition in product

and resource markets, as well as by lowering the

prices of many commodities to US consumers.

Because the US economy is so much larger than

Mexico’s, however, US gains from NAFTA as a pro-

portion of its GDP have been much smaller. Canada

was the least affected by NAFTA because Canada

had already negotiated a free trade agreement with

CESifo Forum 4/2010 36

Focus

Page 39: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201037

Focus

the United States in 1988, and so most of its eco-nomic effects had already taken place by the timeNAFTA came into effect in 1994.

References

Fatemi, K. and D. Salvatore (1994), The North American Free TradeAgreement, New York: Pergamon.

Hufbauer, G.C. and J. J. Schott (1992), North American Free Trade:Issues and Recommendations, Washington DC: Institute forInternational Economics.

Hufbauer, G.C. and J.J. Schott (2005), NAFTA Revisited, WashingtonDC: Institute for International Economics.

Hufbauer, G.C. and J.J. Schott (2008), “Nafta’s Bad Rap”, TheInternational Economy 12, 19–23.

IMD (2010), World Competitiveness Report, Lausanne: IMD.

IMF (2010), International Financial Statistic, Washington DC: IMF.

Inter-American Development Bank (2002), Integration in theAmericas, Washington DC: Inter-American Development Bank.

Klein, L. and D. Salvatore (1995), “Welfare Effects of NAFTA”,Journal of Policy Modeling 17, 163–176.

Kose, M.A., G.M. Meredith and C.M. Towe (2004), How HasNAFTA Affected the Mexican Economy? Review and Evidence, IMFWorking Paper WP/04/59.

Lipsey, R.G. (1961), “The Theory of Customs Unions: A GeneralSurvey”, Economic Journal 71, 498–513.

Meade, J. (1955), The Theory of Customs Union, Amsterdam: North-Holland.

Mendoza, G.E. (2010), “The Effect of the Chinese Economy onMexican Maquiladora Employment”, The International TradeJournal 24, 52–83.

OECD (2010), Economic Outlook, Paris: OECD.

Salvatore, D. (2006), “Can NAFTA Be a Steppingstone to MonetaryIntegration in North America?” Economie Internationale 3, 135–148.

Salvatore, D. (2007), “Economic Effects of NAFTA on Mexico”Global Economy Journal 7, 1–12.

Salvatore, D. (2009), “The Challenge to the Liberal Trading System”,Journal of Policy Modeling 31, 593–599.

Salvatore, D. (2010a), “China’s Financial Markets in the GlobalContext, The Chinese Economy 43, 8–21.

Salvatore, D. (2010b), “Globalization, International Competitiveness,and Growth”, Journal of International Commerce, Economics andPolicy (JICEP) 1, 21–32.

Viner, J. (1953), The Customs Union Issue, New York: The CarnegieEndowment for International Peace.

WTO (2009), International Trade Statistics, Geneva: WTO.

Page 40: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 38

Focus

NAFTA AND MEXICO-USMIGRATION: WHAT LESSONS,WHAT NEXT?

PHILIP MARTIN*

One hoped-for side effect of the North American FreeTrade Agreement, which lowered trade and invest-ment barriers between Canada, Mexico and theUnited States beginning in 1 January 1994, was fastereconomic and job growth in Mexico that would slowunwanted Mexico-US migration. Instead, Mexico-USmigration has surged: the number of Mexican-bornUS residents almost tripled to 12 million between1990 and 2010. The NAFTA-related migration hump– the surge in Mexico-US migration to over 500,000 ayear – turned out to be far larger and to persist farlonger than expected, reflecting supply-push condi-tions in Mexico, demand-pull factors in the UnitedStates, and networks that link Mexican workers to USjobs. This paper explains the factors in Mexico andthe United States that allowed Mexico-US migrationto increase rapidly and why it will be hard to reduceMexico-US migration in the short term.

Mexico-US migration

Between 1820 and 2010, over 75 million immigrantsarrived in the United States. About half were fromEurope, including a tenth from the leading country ofimmigration, Germany. However, only four percent ofGerman immigrants arrived since 1980, comparedwith three-fourths of Mexican immigrants, which iswhy Mexico surpassed Germany as the leading coun-try of immigration in 2007. A quarter of the legalimmigrants in the United States and over half ofunauthorized foreigners, were born in Mexico.

How did Mexico become the major source of USimmigrants? In 1800, Mexico and the United Stateshad populations of roughly equal size, six million,

and Mexico’s per capita GDP was about half that ofthe United States. Northern Mexico (now the south-western US states) was transferred to the UnitedStates by the Treaty of Guadalupe Hidalgo in 1848,ending a war that began when American settlersmoved into Mexican territory and rebelled againstMexican authority. The relatively few Mexican resi-dents of what is now the southwestern United Statesbecame Americans, and there was relatively littlemigration and trade between these DistantNeighbors1 for the next century (Riding 1989).

The US population grew with immigration and birthsand the United States industrialized in the first half ofthe 20th century; Mexico had high birth and deathrates, a much slower growing population, and anagrarian economy marked by large landowners andpoor peasants. Early in the 20th century, whenMexico was undergoing a civil war to break up its lat-

ifundia, the US government approved the recruitmentof Mexican workers to come to the United States asguest workers. These so-called Braceros (arms) wereyoung Mexican men admitted legally between 1917and 1921 and again between 1942 and 1964 to workon US farms and railroads.

Both of the Bracero programs that brought Mexicanmen into the United States as guest workers began dur-ing wartime emergencies, when farmers said that theyfaced a shortage of labor. Both got larger and lastedlonger than expected because of distortion and depen-dence. Distortion reflects the assumptions of US farm-ers that Braceros would continue to be available,prompting investments in orchards and vineyards thatmay not be profitable if a reduced inflow of Bracerosraised wages, which prompted farmers to resist effortsto reduce or end the Bracero program (Martin 2009).

Meanwhile, some Mexicans became dependent onhigher wage US jobs, and moved their families to theborder to increase the chance of being selected as aBracero.2 When the Bracero program ended in 1964,

* University of California, Davis.

1 Mexico’s desire to avoid closer ties with the United States was sum-marized in the aphorism, ‘Poor Mexico, so far from God, so close tothe US’.2 Farmers had to pay transportation costs from the place of recruit-ment in Mexico. By moving to border cities, Mexicans improvedtheir chances of being selected by US farmers.

Page 41: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201039

Focus

during the height of the Civil Rights movement and

amidst concern about poor Americans, thousands of

Braceros and their families in Mexican border cities

had no way to earn a living. In a bid to discourage

them from migrating to the United States, the

Mexican and US governments modified their trade

laws to allow the creation of maquiladoras, factories

in Mexican border cities that imported components,

hired Mexican workers to assemble them into goods

such as TVs, and re-exported the finished products.

The maquiladoras never provided many jobs for ex-

Braceros, who were almost all men, because they pre-

ferred to hire young women.

Even though many rural Mexicans had experience

working in US agriculture, there was relatively little

illegal Mexico-US migration during the 1960s and

early 1970s, the so-called golden era for US farm

workers. About 110,000 Mexicans were apprehended

just inside the Mexico-US border in FY65, the year

after the Bracero program ended. The number of

apprehensions gradually rose, reaching 420,000 in

FY71 and topping a million in FY77 and FY78, when

the leader of the United Farm Workers, Cesar

Chavez, complained that Mexican ‘wetbacks’ were

making it hard for US farm workers to win wage

increases (Martin 2003).

Mexico had extremely high population growth rates

during the 1960s, when Mexican women averaged

7.2 children. After oil was discovered in the Mexican

part of the Gulf of Mexico in 1978, the Mexican

government, anticipating ever-higher oil revenues,

went on an unsustainable spending spree that ended

with a sharp peso devaluation in 1982 and increased

illegal migration to the United States. Appre-

hensions of Mexicans just inside the Mexico-US

border topped 1.2 million in FY83, and averaged

about 1.5 million a year for the next 15 years. The

Border Patrol handled internal enforcement within

the United States, and agents seeking unauthorized

foreigners would surround farms and workplaces

and try to catch workers who ran away. However,

employers were not punished for hiring unautho-

rized workers, and there was not enough enforce-

ment to prevent their spread from farms to con-

struction sites, factories and restaurants.

The US government responded to rising illegal

Mexico-US migration with the Immigration Reform

and Control Act (IRCA) of 1986, which introduced

penalties on US employers who knowingly hired

unauthorized workers. The theory was that ‘closing

the labor market door’ would discourage Mexicansfrom attempting illegal entry over the loosely guarded2,000 mile border, since it would not be worth takingthe risk to cross the border illegally if employersshunned unauthorized workers to avoid fines. How-ever, unauthorized Mexicans soon learned that theycould still get US jobs by showing forged documentsor documents belonging to legal workers, enablingthose who eluded border agents to find jobs as before.Meanwhile, IRCA legalized 2.7 million unauthorizedforeigners, 75 percent Mexicans, creating millions ofnew links between legal Mexicans in the United Statesand their relatives and friends in Mexico.

In 1990, there were 4.3 million Mexican-born US res-idents, and most were legally in the United States as aresult of the legalization in 1987–1988. The number ofMexican-born US residents tripled over the next twodecades to 12 million, and today over half are notauthorized to be in the United States. This means thattwo-thirds of Mexican-born US residents arrivedsince 1990, and most are unauthorized, despite legal-ization to wipe the slate clean and enforcement effortsaimed at deterring their entry. The third element in theeffort to deter unauthorized Mexico-US migrationwas NAFTA, a trade and investment agreement thatwas expected to speed up economic and job growth inMexico keep Mexicans there.

NAFTA and migration

Mexico in the mid-1980s changed its economic poli-cies from inward-looking to outward-looking, shiftingfrom a policy that protected local industries fromimports to a policy that lowered trade barriers toattract foreign investors. Mexico joined the GeneralAgreement on Tariffs and Trade in 1986 (now theWorld Trade Organization). A Canada-US Free TradeAgreement (FTA) went into effect with little fanfarein 1989, prompting the Mexican government to pro-pose its own FTA with the United States in 1990. Theresult was the North American Free TradeAgreement, which went into effect 1 January 1994.Mexico’s then President, Carlos Salinas, asserted thatlowering trade and investment barriers in NorthAmerica would allow Mexico ‘to export goods, notpeople’.3

NAFTA put Mexico on the economic map for USand other foreign investors. Foreign investment

3 Quoted in Elisabeth Malkin, “Nafta’s Promise, Unfulfilled”, New York Times, 24 March 2009.

Page 42: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 40

Focus

poured in and trade increased, making Mexico the

second-largest trading partner of the United States,

after Canada. But NAFTA got off to a rough start in

Mexico, with a sharp peso devaluation in 1994 and a

deep recession that sharply lowered wages and

increased unemployment. NAFTA hastened changes

already underway in Mexico, such as accelerating

rural-urban migration. Many young women left rural

areas to seek jobs in border-area maquiladoras, and

many young men headed to the United States. For

both men and women, the mantra was ‘go north for

opportunity’.

Rural Mexico presented a special challenge. When

NAFTA went into effect in 1994, a quarter of

Mexicans lived in rural areas, three fourths of

Mexico’s poverty was in rural areas, and over half of

the Mexicans in the United States were from rural

Mexico. During the Mexican Revolution of

1910–1917, the battle cry was land for the peasants,

and Article 27 of the Mexican constitution redistrib-

uted large landholdings into ejidos whose farmer-

members could farm their land, and pass it on to their

heirs, but not rent or sell it. In 1992, after decades of

rural poverty, the Mexican government modified

Article 27 in anticipation of NAFTA to allow the

rental and sale of ejido land, assuming that ejido

members agreed (Cornelius and Myhre 1998).

The combination of allowing ejido land to be rented

or sold and the employment and wage changes asso-

ciated with NAFTA signaled especially young people

in rural Mexico that their future lay elsewhere. One

dimension of the displacement challenge in Mexico is

evident in corn production. In the early 1990s, the US

state of Iowa produced twice as much corn as the

country of Mexico, and at about half the price the

Mexican government offered to farmers who had corn

to sell. With about half of the days worked in

Mexican agriculture devoted to corn production, free-

ing up trade in corn meant that millions of rural

Mexicans would have to find alternative jobs. The

hope was that many Mexican farmers would shift

from producing corn to labor-intensive fruits and veg-

etables, but lack of knowledge, investment, and infra-

structure, plus the continued availability of Mexican

farm workers in the United States, meant that much

of the growth in labor-intensive agriculture occurred

in the United States rather than Mexico.

Mexicans could have stayed in Mexico and found

non-farm jobs. However, the creation of formal sec-

tor jobs has been too slow to absorb the growing

labor force and make a dent in widespread underem-ployment. Mexico’s GDP growth has been less thanthree percent over the past three decades, includingthe 15 years since NAFTA went into effect; with thepopulation growing by over one percent a year, percapita GDP growth averaged about 1.5 percent peryear. The gap between GDP per capita in the UnitedStates and Mexico, about five to one according tothe World Bank, has narrowed only slightly sinceNAFTA went into effect in 1994, when the gap wasabout six to one.

Most experts say that the Mexican economy mustaverage six percent economic growth to create enoughjobs to reduce the gap in GDP per capita and the eco-nomic incentive to migrate (Weintraub 2010).4 TheMexican education system must also be reformed tojustify higher Mexican wages. Mexicans adults in2010 have an average eight years schooling. TheMexican government via the Opportunidades(Progresa from 1997–2002) is trying to break theinter-generational transmission of poverty by educat-ing children, providing payments to the mothers ofpoor children every two months if the child was inschool at least 85 percent of the time. The paymentsincrease as children get older, reflecting the risingopportunity cost of going to school, since 15 and16 year olds could work and earn more than youngerchildren (Levy 2006). In 2010, Opportunidades pro-vided support to five million poor Mexican families(there are about 26 million families in Mexico) at acost of 3.6 billion US dollars. About 85 percent ofOpportunidades recipients are in rural Mexico.

By 2010, Mexico had a population of 110 million anda labor force of 45 million. Both the population andlabor force are expanding by a million a year (OECD2010). Mexico offers too few formal-sector jobs tokeep Mexicans at home. Only half of Mexico’s work-ers are wage and salary employees, according to theOECD, and many of those who appear to have formalsector jobs are employed only part time, making themineligible for these benefits. The number of privatesector jobs enrolled in IMSS, Mexico’s social securitysystem, has remained at about 15 million since 2000.There are about eight million Mexican-born workersin the United States, which means that a third ofMexicans with formal-sector jobs are in the UnitedStates. Until Mexico can add formal-sector jobs at afaster pace over time, especially young Mexicans with

4 Weintraub (2010) characterizes the Mexico-US relationship asdependent-dominant, that is, the Mexican economy is dependent onthe dominant United States to accept its exports and its migrants.

Page 43: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201041

Focus

friends and relatives already in the United States will

continue to migrate north for opportunity.

The migration hump

NAFTA accelerated changes already underway in

Mexico, adding to rural-urban migration, creating

higher wage jobs near the Mexico-US border, and

displacing workers from jobs in previously protect-

ed industries in central Mexico. These NAFTA-

linked changes meant that some Mexicans who

were previously protected behind trade barriers in

agriculture and industry had to find new jobs, and

made it clear to many small farmers in rural

Mexico that a better life lay elsewhere. However,

poor education systems in rural Mexico meant that

many of those leaving rural Mexico were not pre-

pared for good jobs in Mexico or the United States

(Levy 2008).

NAFTA provides an example of an economic policy

that produces pain before gain, that is, the same

trade and investment policies that should reduce

unwanted international migration in the long term

can increase such migration in the short term.

Analyses of free trade agreements generally find that

countries that are more fully integrated into the

world economy grow faster than countries that are

more closed to the global economy. However, these

comparative static analyses are based on before and

after comparisons; they often ignore the migration

that occurs as richer and poorer economies with a

pre-existing migration relationship lower barriers to

trade and investment.

International migration, legal and unauthorized, can

rise as especially poorer economies already experienc-

ing out-migration adjust to economic integration, cre-

ating a migration hump. Reducing trade barriers can

displace workers in both poorer and richer countries,

as when garment and auto parts factories closed in

the United States when these factories shifted to

Mexico and Mexican farmers and workers making

heavy equipment lose their jobs as imports from the

United States rise. The displaced US workers rarely

migrate to Mexico, but some of those displaced in

Mexico migrate to the United States, so that migra-

tion and trade can increase together, especially if freer

trade displaces Mexican workers faster than foreign

investment creates new jobs in Mexico. Eventually,

faster economic and job growth in Mexico should

reduce Mexico-US migration.

The migration hump is pictured in Figure 1. The

solid line through B represents the rising migration

expected without economic integration as a result of

rapid labor force and slow formal sector growth in

Mexico. The extra migration in the hump is pictured

above A, which shows how economic integration

leads to an increase in migration over the status quo

trajectory. However, economic integration should

also speed up economic and job growth in Mexico,

so that migration falls below the status quo level at

B, after 15 years in the figure. As faster economic

and job growth in Mexico continues, migration is

projected to fall even more, and area C represents the

migration avoided by economic integration.

Eventually, some migrants may return from abroad

as net emigration turns into net immigration, as

occurred in Ireland, Italy and Spain.

Table 1

Mexico-US population and labor force 1970–2010

Year Mexico United States

1970 Population (million)

Labor force (million)

Labor force as a share of population (%)

53

15

28

203

83

41

Population (million)

Labor force (million)

Labor force as a share of population (%)

110

45

40

310

155

50

2010

Employment

Total formal sector jobs (million)

• Filled with Mexicans (million)

Employment in Agriculture (million)

• Filled with Mexicans (million)

15

15

7

7

125

6

3

2

2050 Population (million)

Labor force (million)

Labor force growth 2010–2050 (%)

130

65

45

425

212

37

Sources: US Census and Conapo for the United States, 2050 projections from Population Reference Bureau

(PRB); Instituto Mexicano del Seguro Social (IMSS), Subdirección General de Finanzas for Mexico.

Page 44: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 42

Focus

The critical policy parameters are A, B, and C – howmuch additional migration results from economicintegration (A), how soon does the hump disappearas migration returns to the status quo level (B), andhow much migration is avoided by economic integra-tion and other changes (C)? Generally, there must bea pre-existing migration relationship and three morefactors for economic integration between poorer andricher countries to lead to a migration hump: a con-tinued demand-pull for migrants in the destinationcountry, an increased supply-push in the country oforigin as freer trade displaces workers and accelerateschanges under way such as rural-urban migration,and migration networks that can move workersacross borders.

These conditions were present in the case of Mexicoand the United States. Migration was the major rela-tionship between Mexico and the United States formost of the past half century, which enabled migra-tion networks to make rural Mexicans aware of jobopportunities in the United States. The US govern-ment did not develop an effective policy to keep unau-thorized workers out of US jobs and, when Mexicangovernment policies and NAFTA accelerated dis-placement in rural Mexico, more Mexicans migratedto the United States. Today, 10 percent of the 120 mil-lion people born in Mexico live in the United States.With their US-born children, the United States hasabsorbed at least 25 million people who would other-wise live in Mexico.

There are three central policy messages of the migra-tion hump. The first is the need for policy makers toacknowledge the potential for a pain-before-gain

increase in migration with closereconomic integration, requiringe.g. the Mexican government tocooperate to reduce the openmassing of Mexicans on theMexican side of the border toattempt illegal US entry. The sec-ond policy message is that tradeand other policies should beimplemented in ways that makethe migration hump smaller andshorter, such as phasing in freertrade slowly in areas with themost labor displacement and notchanging policies that add tomigration, as when Mexicoallowed the rental and sale of

ejido land at about the same timethat NAFTA went into effect.

The third policy message is to link economic integra-tion with enhanced cooperation to manage migrationso that the migration hump migration does not lead toa backlash that slows freer trade and investment.Mexican and US trade negotiators, saying that it washard enough to negotiate NAFTA, took migration offthe table. Except for NAFTA’s Chapter 16, which cre-ates freedom of movement for college educated resi-dents of Canada, Mexico, and the United States whohave job offers in another NAFTA country5, migra-tion is not dealt with in NAFTA.

Mexican and US responses

The Mexican government’s response to risingMexico-US migration in the 1990s was to emphasizethat most Mexican migrants found US jobs, suggest-ing that they were needed because US employershired them. The Mexican government argued that themigration hump should be turned into legal migra-tion with a guest worker program negotiated cooper-atively. Then Mexican Foreign Relations SecretaryJose Angel Gurria in 1996 said: “the phenomenon ofmigration can be beneficial and offers great potentialadvantages to both the migrants’ original and newcountries, but only when a common vision on thisphenomenon is reached”.6

0 5 10 15 20 25 30 35 40

Source: Author's conception.

THE MIGRATION HUMP Migration flow

Status quo pattern

Migration avoidedC

A B

Additional migration

Migration pattern witheconomic restructuring

Year ofeconomic

restructuring

DYears

Figure 1

5 The major effect of Chapter 16 has been to move Canadian profes-sionals into US jobs with TN visas. About 20 percent of Mexicanswith doctorates are in the United States, and half of the20,000 Mexican PhD holders in the United States entered since 1990.6 Quoted in Migration News (1996), Mexican Views onImmigration, Vol. 3, No. 11,http://migration.ucdavis.edu/mn/more.php?id=1072_0_2_0

Page 45: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201043

Focus

The efforts of commissions and task forces to designmutually acceptable guest worker programs were notsuccessful, even during the late 1990s when the USunemployment rate dipped below five percent. Therewas hope for a new era in Mexico-US migration in2000, when Mexicans elected Vicente Fox President inJuly 2000, breaking the 70-year hold of theInstitutional Revolutionary Party (PRI) on power,and George W. Bush, who advocated a new guestworker program during the campaign, was elected USPresident in November 2000.

During the spring and summer of 2001, Fox pressedBush for a comprehensive immigration reform. Foxwas especially bold in calling for freedom of move-ment. In January 2001, Fox said: “when we think of2025, there is not going to be a border. There will bea free movement of people just like the free move-ment of goods”.7 Some US and Mexican advisorsurged Fox to press for more than just a guest workerprogram, and Mexican Foreign Minister JorgeCastaneda in June 2001 summarized Mexico’s four-pronged immigration agenda to include legalizationfor unauthorized Mexicans, a large guest-worker pro-gram, a reduction in border violence and an exemp-tion of Mexico from visa quotas, ending with whatbecame a memorable phrase: “it’s the whole enchila-

da or nothing”.

Fox and Castenada were in Washington DC justbefore the 11 September 2001 terrorist attacks, whenFox said that he expected the United States to enactcomprehensive immigration reform before the end ofthe year.8 The terrorist attacks turned attention else-where and accelerated the addition of Border Patrolagents and fences on the Mexico-US border so thatterrorists could not use the migration infrastructuredeveloped to move Mexican workers into the UnitedStates. Smuggling fees rose from 200 to 300 US dol-lars in the early 1990s to 2,000 to 3,000 US dollars adecade later, and migrants who paid more to enter theUnited States illegally were more likely to settlebecause of the difficulty and expense of re-entry.

In 2005, when the US unemployment rate droppedtoward five percent and unauthorized Mexicans dif-

fused throughout the United States in agriculture,construction and services, Congress once again tack-led Mexico-US migration. Under Republican leader-ship, the House approved the Border Protection,Antiterrorism, and Illegal Immigration Control Actin December 2005, which took an enforcement-onlyapproach to unauthorized migration. The House billcalled for mandatory screening of newly hired as wellas existing employees to ensure they are legally autho-rized to work in the United States and would havemade ‘illegal presence’ in the United States a felony,which would have made harder for unauthorized for-eigners to eventually become legal immigrants. Thisso-called Sensenbrenner bill prompted massivedemonstrations against an enforcement-onlyapproach and in favor of legalization in spring 2006,culminating in a May 1 ‘day without immigrants’protest.

Under Democratic leadership, the Senate took a dif-ferent approach, approving the ComprehensiveImmigration Reform Act (CIRA) in May 2006.CIRA included more enforcement, as in the Housebill, as well as new earned legalization and guestworker programs. Unauthorized foreigners in theUnited States at least five years could become ‘pro-bationary immigrants’ by proving they had worked inthe United States, paid any back taxes owed and aUSD 1,500 fee, and passed English and backgroundtests. After six years of continued US work and taxpayments and another USD 1,500 fee, they couldapply for immigrant visas, a process called fees are‘earned legalization’.9 This so-called Kennedy-McCain bill approved by the Senate was not consid-ered by the House and died.

The Senate debated a revised Comprehensive Immi-gration Reform Act (CIRA) in 2007 that was tougheron unauthorized foreigners, but opponents blocked avote on the bill despite the active support of PresidentGeorge W. Bush. During the 2008 presidential cam-paign, Barack Obama expressed support for CIRA,but John McCain reversed his previous support andsaid that enforcement must precede legalization.Obama has several times repeated his support for com-prehensive immigration reform, but Congressionalaction has been blocked by opponents of legalizationand opponents of new enforcement efforts that couldincrease discrimination against minorities.

7 Quoted in Migration News (2001). Mexico: Guest Workers, Vol. 8,No. 2, http://migration.ucdavis.edu/mn/more.php?id=2297_0_2_08 Fox said: “the time has come to give migrants and their communi-ties their proper place in the history of our bilateral relations … wemust, and we can, reach an agreement on migration before the endof this very year ... [so that] there are no Mexicans who have notentered this country legally in the United States, and that thoseMexicans who come into the country do so with proper documents”– quoted in Migration News (2001), Fox Visits Bush, Vol. 8, No. 10,http://migration.ucdavis.edu/mn/more.php?id=2463_0_2_0.

9 Unauthorized foreigners in the United States for two to five yearswould have to satisfy the same requirements, but in addition returnto their countries of origin and re-enter the United States legally, andthose in the United States less than two years would be expected todepart, although they could return legally as guest workers.

Page 46: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 44

Focus

The stalemate in Congress has encouraged somestates and cities to enact laws to deal with illegalmigration. Some have been friendly to unauthorizedforeigners, such as issuing them ID cards or prohibit-ing police from asking about the immigration statusof persons they encounter, but most have aimed tomake life difficult for unauthorized foreigners.Arizona in April 2010 enacted the Support Our LawEnforcement and Safe Neighborhoods Act (SB 1070),which makes it a state crime for unauthorized for-eigners to be in the state. A federal court injunctionblocked SB 1070 from going into effect, agreeing withopponents that regulating immigration was strictly afederal responsibility. Mexican President FelipeCalderón, who reportedly has relatives living illegallyin the United States, said that SB 1070 “introduces aterrible idea: using racial profiling as a basis for lawenforcement”.

Legal and unauthorized Mexico-US migration con-tinues with no end in sight. Economic and jobgrowth in Mexico was slowed by the 2008–2009recession and by longer term factors that range fromthe rising preference of some foreign investors forChina and other Asian countries to a governmenteffort to deal with drug gangs that left over30,000 people dead in four years. The United States,which has about 15 million unemployed workers, isprojected to have an unemployment of over nine per-cent for the next several years, and to experienceespecially slow growth in the residential constructionemployment that employed many Mexican-bornworkers.10 Sluggish growth and drug wars in Mexicomay encourage Mexicans to migrate northward,while more border enforcement and high unemploy-ment may counter this migration, making migrationa continued irritant in Mexico-US relations even asNAFTA promotes economic integration.

References

Cornelius, W. and D. Myhre (1998, eds.), The Transformation of RuralMexico: Reforming the Ejido Sector, Boulder: Lynne Rienner Pub-lishers.

Levy, S. (2006), Progress Against Poverty: Sustaining Mexico’sProgresa-Oportunidades Program, Washington DC: Brookings Insti-tution.

Levy, S. (2008), Good Intentions, Bad Outcomes: Social Policy,Informality, and Economic Growth in Mexico, Washington DC:Brookings Institution.

Martin, P. (2009), Importing Poverty? Immigration and the ChangingFace of Rural America, New Haven: Yale University Press.

Riding, A. (1989), Distant Neighbors: A Portrait of the Mexicans,New York: Vintage.

Weintraub, S. (2010), Unequal Partners: The United States and Mexi-co, Pittsburgh: University of Pittsburgh Press.

10 Employment in residential building construction (NAICS) peakedat a million in 2006 and fell below 600,000 in 2010.

Page 47: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201045

Focus

NORTH AMERICA’S UPHILL

BATTLE ON CLIMATE CHANGE

AND ITS IMPLICATIONS FOR

THE NORTH AMERICAN

TRADING SYSTEM

MEERA FICKLING*

Introduction

As the debate over climate change legislation brewedin the US House and Senate in 2009 and early 2010,its implications for heavily traded manufacturing werehotly contested. Concerned that higher energy priceswould cause firms to produce these goods outside theUnited States instead of complying with US regula-tions, lawmakers offered free emissions allowances tocompensate domestic firms and threatened to requireimporters from countries that did not meet US cli-mate standards to purchase emissions allowances atthe border.

A year later, passage of US climate legislation nowseems all but impossible. As the United States hasbacked away from its initial ambitions, NorthAmerica as a whole seems likely to follow suit. Asidefrom anemic federal regulation under the US CleanAir Act, climate change legislation has been left up tostates and provinces for the time being.

The fragmentation of climate change policy has itsown implications for North American trade andinvestment. Though the scale is now far smaller, regu-lation at the provincial level makes it more likely thatemissions could migrate to other areas. States andprovinces also have less capacity to adjust their trans-mission infrastructure to ramp up renewable electrici-ty production at least cost. This does not mean thatstate and provincial policy is not crucial to North

America’s climate change mitigation goals – for now,it seems that state policy is the only feasible means ofworking toward climate change mitigation in NorthAmerica. However, this is not the best possible situa-tion. Federal climate policy, though jettisoned due toconcerns about jobs and competitiveness, would actu-ally be more effective at reducing emissions withoutadverse trade impacts.

The volume of North American energy trade is large.The United States derives about a fifth of its oil fromCanada, and in 2008 about two thirds of the crude oilproduced in Canada was shipped to the UnitedStates.1 Canada is the largest supplier by far of ener-gy-intensive manufactures to the United States,including steel (20 percent of US imports), cement(53 percent of US imports), paper (52 percent of USimports), and aluminum (55 percent of US imports).In total, Canada exported USD 44 billion of highlytraded, energy-intensive products to the United Statesin 2008 (Hufbauer and Kim 2009).2

As a consequence, it is important to understandwhat state legislation means for trade in energy andenergy-intensive goods. This paper explores thisissue below.

Prospects for North American action

Federal

Prospects for comprehensive federal climate changelegislation in North America are not bright. Thoughthe United States seemed promising in 2009, with thepassage of the Waxman-Markey bill through theHouse of Representatives, legislation stalled in theSenate in 2010 as partisan acrimony intensified andthe political mood soured on cap-and-trade. To cap itoff, the Democratic Party, which is far more support-ive of climate change legislation, experienced heavylosses in Congressional midterm elections. There is lit-tle likelihood in the near future that Republicans in

* Peterson Institute for International Economics, Washington DC.This article draws heavily on the forthcoming book, NAFTA andClimate Change by Meera Fickling and Jeffrey J. Schott, to be pub-lished by the Peterson Institute for International Economics inearly 2011.

1 Data obtained from the Energy Information Administration andStatistics Canada, 2009.2 Based on products scheduled to receive allowance rebates under theWaxman-Markey and Kerry-Lieberman bills.

Page 48: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

the House and the Senate will rally around a keyObama initiative that most of them campaignedagainst. Even initiatives such as a renewable portfoliostandard that once seemed politically safe now seemless likely.

Environmental advocates have turned to new chan-nels. One of the chief tools in the ObamaAdministration’s arsenal is the Clean Air Act, which isadministered by the Environmental ProtectionAgency (EPA). In 2007, the Supreme Court ruled thatthe EPA had the authority to regulate greenhousegases (GHGs), which cause climate change, under theAct.3 Technically, the EPA could achieve substantialGHG emissions reductions through this approach(Bianco and Litz 2010) – but this would involve imple-menting a much more far-reaching regime thanCongress is likely to allow. Already, a number of res-olutions have been introduced in Congress to limit theEPA’s powers. These measures have so far been kept atbay, but the incoming Congress promises to be evenless sympathetic to the EPA than before.

So far, EPA regulation has been modest. The EPA hasannounced that it will require new sources and majormodifications producing more than 75,000 tons ofCO2e per year – in other words, new projects thatwould produce a large amount of emissions – to obtainPrevention of Significant Deterioration (PSD) permits.The PSD permitting system is administered on a state-by-state basis. In November 2010, the EPA released itsproposed guidance to the states for PSD permitting.The document indicates that a relatively lenientapproach will be taken toward coal-fired power plants,relative to the possibilities. Energy efficiency improve-ments are on the table, but the guidance document dis-courages states from requiring coal-fired power plantsto switch to coal or biomass or implement carbon cap-ture and sequestration.4 These energy efficiencyimprovements are not expected to produce substantialemissions reductions; Richardson et al. (2010) estimatethat modest energy efficiency improvements in coalplants could reduce GHG emissions by 3 percent.

If the United States is not able to pull together a pro-gram to substantially reduce GHGs, Canada isunlikely to do so either. Over the past couple of years,the Canadian government has transitioned from atleast a nominal policy-maker on climate change to a

taker of policy from the United States. In 2007, theCanadian government released Turning the Corner, arelatively ambitious plan that aimed to reduce emis-sions by 20 percent from 2006 levels by 2020.Subsequently, citing fears of lost industrial competi-tiveness, it has backed away from this plan and insteadpromised to emulate whatever the US action turnedout to be. By early 2010, Canada had shifted so fartoward this stance that its Copenhagen pledge read,“17 percent, to be aligned with the final economy-wide emissions target of enacted US legislation”(UNFCCC 2010a).

The host of the 2010 COP 16 in Cancun, Mexico hasshown international leadership on climate change. Atthe 14th session of the UNFCCC Conference ofParties (COP 14) in Poznan, Poland in December2008, it announced its intention to reduce emissions50 percent from 2002 levels by 2050, contingent upondeveloped-country assistance. In the run-up toCopenhagen, Mexico proposed a ‘Green Fund’, awell-received plan to provide 10 billion US dollars peryear toward mitigation, adaptation, and technologytransfer. And its Copenhagen submission committedto reduce emissions 51 MMT below business-as-usuallevels by 2012 (equivalent to about a 6.4 percent cut)and 30 percent below business as usual by 2020(equivalent to about 250 MMT of carbon dioxide-equivalent) – see UNFCCC (2010b).5

Mexico has been active at home as well. Its 2009Special Climate Change Program (PECC) lays out anumber of actions toward meeting its 2012Copenhagen target, as well as the agencies responsiblefor their implementation, the Secretariat ofEnvironment and Natural Resources (SEMARNAT)and the National Energy Secretariat (SENER).Proposed actions include management of landfill gas;expansion of sustainable forest management, includ-ing expansion of the payment for environmental ser-vices scheme; self-supply schemes for renewable ener-gy; and wind power generation by the FederalElectricity Commission (CFE).

However, all of Mexico’s ambitious undertakings areconditioned upon adequate financing from developedcountries.6 And foreseeable funding sources depend at

CESifo Forum 4/2010 46

Focus

3 Commonwealth of Massachusetts v. Environmental ProtectionAgency. 4 Carbon capture and sequestration technology is not yet commer-cially viable.

5 The 2012 percentage emissions reduction estimate and the 2020absolute emissions reduction estimate are calculated by the authorsbased on business-as-usual emissions projections in Centro MarioMolina (2008). 6 Mexico’s commitment to reduce emissions 30 percent by 2020 isconditioned upon “the provision of adequate financial and techno-logical support from developed countries as part of a global agree-ment” (UNFCCC 2010b), and its Poznan commitment is also con-tingent upon developed country financing.

Page 49: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201047

Focus

least in part on the United States. US Secretary of

State Hillary Clinton provided the impetus behind the

USD 100 billion climate change fund promised at

Copenhagen, and the United States will be expected

to make a substantial contribution to this fund. A US

cap-and-trade program with offset and allowance

trading provisions could provide additional financial

incentives for Mexican firms to use cleaner technolo-

gies and production methods. While Mexico might

benefit from selling renewable electricity and carbon

offsets to California, which is implementing climate

change legislation on a far smaller scale, it seems

unlikely that the United States Congress will make cli-

mate change a high priority in the near future. As a

consequence, the United States cannot be counted on

as a key source of funding in the near future.

State

Despite the dismal outlook described above, climate

change regulations cannot be written off just yet.

Action is occurring at the sub-federal level. The

Regional Greenhouse Gas Initiative (RGGI), a cap-

and-trade system for electricity emissions operated by

a group of Northeastern US states, has been active

since September 2008. The RGGI aims to reduce

emissions produced from electricity by 12 percent by

2020. While emissions reductions are not required

until 2015, auctions have been taking place since the

program became active.

California is creating a cap-and-trade program and

recently released its proposed regulations. This regu-

lation is part of the Western Climate Initiative

(WCI), a group of US states and Canadian provinces

that have promised to reduce their economies’ emis-

sions by 15 percent from 2005 levels by 2020. The

program will cover 85 percent of the state’s emis-

sions and will take effect in 2012 for electricity gen-

erators and large industrial sources and 2015 for

transportation, residential and commercial fuels.

Other parties that do not fall into these categories

can voluntarily opt into the emissions trading pro-

gram (Fickling 2010).

A few Canadian provinces, together comprising

about half of Canada’s emissions, also appear on

track to implement cap-and-trade programs under

the WCI banner by 2012. British Columbia, Que-

bec, and Ontario have all passed bills authorizing

cap-and-trade systems, and British Columbia

released draft regulations in October 2010 (Fickling

2010).

In addition, states have implemented a number of per-

formance standards. One of the most prominent is the

renewable portfolio standard, which requires utilities

to procure a certain percentage of total retail electric-

ity sales from renewable sources. This standard has

been implemented in thirty US states and a handful of

Canadian provinces. Target renewable percentages

range from California’s standard, which aims to meet

a third of the state’s electricity demand though renew-

able resources by 2020, to Texas’s standard, which

requires utilities to procure 5 percent of electricity

from renewable sources by 2015 (Fickling 2010).

Sources that are most often eligible to fulfill state

renewable energy standards include wind, solar,

geothermal, landfill gas, and ocean energy. Hydro-

power, biomass, and municipal solid waste tend to

be given lower priority under a renewable portfolio

standard, if such sources are eligible at all.

Renewable portfolio standards are often combined

with energy efficiency resource standards, which

require utilities to reduce demand through energy

efficiency measures (Fickling 2010).

Another measure that has gained some traction in the

United States is the low-carbon fuel standard (LCFS),

which is currently being piloted by California. The

LCFS is intended to replace the state’s ethanol blend-

ing requirement, which has been criticized for failing

to discriminate between relatively GHG-intensive bio-

fuels such as corn-based ethanol and lower-impact

biofuels such as sugarcane and cellulosic ethanol.

Instead, the LCFS requires the California Air

Resources Board (CARB) to assign a GHG intensity

value to each transport fuel sold in California.

To obtain these values, CARB must quantify the

GHGs emitted over the lifecycle of a fuel, from the

extraction of the raw materials used to produce the

fuel to the burning of the fuel in one’s car. The

standard then requires fuel retailers to reduce the

GHG intensity of their fuel sales by 10 percent by

2020. Proponents of the standard argue that this

process emphasizes reducing carbon emissions

rather than promoting American corn growers,

although critics argue that CARB uses a flawed

methodology to calculate lifecycle intensity values

(Fickling and Schott 2011).

Trilateral

At least until Canadian Environment Minister Jim

Prentice left office in November 2010, trilateral dia-

Page 50: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

logue on climate change policy benefited from a close

working relationship among the three environment

ministers, as well as a commitment to trilateral energy

cooperation among heads of state. After nearly a

decade of inaction on climate change policy, the

North American Leaders’ Summit in August 2009

refocused attention on sustainable energy issues and

instructed officials to develop a trilateral working

plan for cooperation on energy science and technolo-

gy. North American environmental ministers also

committed to improving the comparability of data

gathering and inventories for mitigation and adapta-

tion projects at the NAFTA Commission for

Environmental Cooperation (CEC) ministerial in

August 2010.

Bilateral arrangements were also advanced. In

2009, US President Barack Obama and Canadian

Prime Minister Stephen Harper established a Clean

Energy Dialogue to coordinate on carbon capture

and storage research and modernization of the elec-

tric grid. Obama and Mexican President Felipe

Calderon created the US-Mexico Bilateral

Framework on Clean Energy and Climate Change,

agreeing to collaborate on low-carbon technology

development and capacity building, as well as adap-

tation to climate change.

A substantial roadblock is the low level of funding for

climate change activities within NAFTA environmen-

tal institutions. The CEC amasses environmental

information, provides recommendations on trilateral

environmental issues, and promotes environmental

law enforcement – all with a 9 million US dollar bud-

get. The amount of money allocated to the CEC has

remained unchanged since its creation in 1994, despite

inflation and exchange rate movements (the budget is

expressed in dollars, while the CEC is physically locat-

ed in Canada) that have decreased the real value of

this amount. Although the CEC has been effective for

its size, its budget constrains the scope of its opera-

tions (Hufbauer and Schott 2005).

The North American Development Bank (NADB)

and Border Environment Cooperation Commission

(BECC), two interrelated institutions that fund envi-

ronmental projects on the US-Mexico border, receive

far more money in the form of cash and loan guaran-

tees. The capital base of the NADB is 3 billion US

dollars per year (Hufbauer and Schott 2005). Lending

started out far below this capacity due to high interest

rates and a cumbersome application process, but the

NADB/BECC has improved markedly in recent years,

offering subsidized loans to needy communities and

grants from paid-in capital (Kass and McCarroll

2008). Total loans disbursed have skyrocketed from

USD 11 million as of 2002 to USD 1.1 billion as of

September 2010 (NADB 2010). While the scope of

the NADB/BECC has officially expanded to include

renewable energy and energy efficiency, however, these

issues still make up a tiny portion of the institutions’

overall lending portfolio (NADB 2010).

What does this mean for North America?

State policies are an improvement over no policy.

State environmental regulation has historically served

as a ‘laboratory for innovation’, paving the way for

more stringent federal environmental policy than

would otherwise be adopted and allowing ideas to be

tested on a small scale before they are implemented

nationally. A prominent recent example is California’s

‘Pavley’ automobile tailpipe emissions standards,

which required automakers to achieve a fleet average

fuel efficiency of 36 miles per gallon. After fourteen

other US states and four Canadian provinces adopted

these requirements, the federal governments of the

United States and Canada implemented them on a

national scale.

However, the fragmentation of climate policy is ideal

neither for the climate nor for the North American

trading system. A robust network of state cap-and-

trade regimes could generate substantial reductions.

But the group of states likely to adopt a cap-and-

trade approach – a handful of Northeastern states

and Canadian provinces, plus California – cannot

produce anything close to the amount of reductions

promised by the United States and Canada in

Copenhagen.

State climate policy is more susceptible to so-called

‘carbon leakage’. Leakage can occur at either the pro-

ducer or the consumer level. Climate change policy

aims to make it more expensive to produce and con-

sume carbon-intensive goods. Because climate policy

is not globally integrated, firms that produce these

goods could simply move to unregulated jurisdictions

rather than reduce their emissions. Likewise, envision

a firm selling two comparable products, one clean and

one dirty, to two places, one with regulations and one

without. The firm could simply sell its dirtier good to

consumers in the unregulated area and its cleaner

good to customers in the regulated area, without nec-

essarily changing its overall production of each good.

CESifo Forum 4/2010 48

Focus

Page 51: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201049

Focus

The extent to which leakage could occur depends

upon a host of factors, including the extent to which

energy prices increase, the energy intensity of in-state

industries, and the ease with which firms can shift

production and sales. States and provinces that are

likely to adopt comprehensive climate change legisla-

tion do not tend to have high concentrations of ener-

gy-intensive, trade-exposed industries. However,

states are particularly economically integrated with

each other, so production and consumption may shift

more easily to unregulated areas than if policy were

adopted at a national level. Modeling of state cap-

and-trade policies produces mixed results as to the

probability of leakage according to RGGI (2007) and

WCI (2008).

In addition, climate policy that is limited to only a

handful of states and provinces could worsen the

already existent disparities in energy consumption

between leading and laggard regions of North

America. The difference between the GHGs emitted

by California and Wyoming per capita is large, partic-

ularly when it comes to the type of electricity used by

the two states. Carbon-intensive production is also

concentrated in certain states and provinces, particu-

larly in the American Midwest and Southeast and the

western Canadian provinces. These regional differ-

ences already pose frictions for North American poli-

cymakers, who have to construct national climate

change regimes without imposing a disproportionate

economic burden on any one region (Fickling and

Schott 2011). If some states make significant progress

before others catch up, this could exacerbate the diffi-

culty of passing national legislation.

There are difficulties coordinating various state stan-

dards. Whereas some standards such as automobile

and fuel standards are modeled off California’s, oth-

ers such as the renewable portfolio standard are

designed on a state-by-state basis, with little agree-

ment as to what constitutes renewable energy or

where it must come from in order to meet a particu-

lar standard. As a result, it is difficult to trade credits

across regions – even though energy from a different

region might achieve the common goal of reducing

emissions.

Economies of scale for renewable generation are less

easily captured through state action. When renewable

electricity is generated over a wide area, rather than in

a single locality, it is less susceptible to changes in

weather patterns. States also cannot single-handedly

create the infrastructure necessary to take full advan-

tage of renewable energy. Expanded transmissionwould allow renewable electricity to be sold fromareas with high potential to areas with lower poten-tial. A recent US Department of Energy report pointsout that wind power could comprise 20 percent ofnational electricity generation if, among other things,transmission capacity were significantly expanded(Department of Energy 2008). A smart grid thatmoves some electricity usage from peak hours to off-peak hours can also help ‘soak up’ excess wind powergenerated during off-peak hours. Such a project mustbe coordinated among many states; one state alonecannot revamp the current antiquated grid.

State standards, trade politics and trade law

Recent US federal cap-and-trade proposals includedwidely debated measures to protect the competitive-ness of domestic manufacturing. Most federal legis-lation introduced after 2007 included a so-calledinternational reserve allowance program (IRAP),which required importers to purchase allowances atthe border to compensate for the difference betweenthe cost of production at home and the cost of pro-duction in unregulated jurisdictions. The IRAP wasimposed based on country of origin – imports fromcountries that had not taken sufficient action on cli-mate change would be subject to the border measure,with exceptions only for least developed countriesand de minimis emitters. The measure was a signifi-cant concern for Canada and Mexico, whose officialsfeared that their large volumes of carbon-intensiveexports could be put at risk.7 It was also of question-able WTO legality.

Even though federal US cap-and-trade legislation isstalled for the time being, Canada and Mexico are notoff the hook. Carbon tariffs are a response to domes-tic political pressures from carbon-intensive industriesthat anticipated a high cost of reducing emissions andtherefore feared a loss of competitiveness. As notedabove, these pressures were particularly potentbecause most carbon-intensive industries are dispro-portionately concentrated in politically importantstates. If these states fall even further behind others in reducing emissions, this will both increase the to-tal amount of emissions that the United States must eventually eliminate in order to meet its interna-tional goals and increase the gap between the cost ofnational climate policy to leading states and the cost

7 For more information, see Schott and Fickling (2009).

Page 52: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

of national climate policy to laggard states. Con-sequently, protectionist pressures could return with avengeance if and when the United States musters thepolitical will to give cap-and-trade another try.

Although state legislation avoids some of the frictionscaused by recent national cap-and-trade proposals,some standards are particularly controversial.Notably, California’s low carbon fuel standard sepa-rates petroleum into two categories: ‘conventional’and ‘unconventional’. Whereas conventional fuels areall assigned the same lifecycle carbon intensity value(equivalent to the weighted average carbon intensityof the fuels consumed in California), unconventionalfuels such as oil sands crude, etc. are given a separatelifecycle analysis. Unsurprisingly, Canada, whichexports 2.5 million barrels of oil sands crude to theUnited States every day, has expressed its concern thatthis measure violates WTO rules.8

At issue is whether the distinction between oil sandscrude and conventional crude is arbitrary or justifi-able. In order to defend its standard before a WTOdispute settlement panel, California would have toprove that environmental considerations require oilsands crude to be treated differently from cruderecovered via conventional drilling processes. Thepanel’s decision could hinge upon whether oil sandscrude is sufficiently more GHG-intensive to merit aseparate category. While oil sands crude is about 15to 20 percent more GHG-intensive than the averageconventional crude to produce and use, the differ-ence between it and heavier crudes is narrower(Toman et al. 2008).

Other standards have created somewhat less contro-versy but have nevertheless proved to be sources offriction between states and provinces. Some renewableportfolio standards require qualifying electricity to beproduced in state, or exclude certain sources of elec-tricity from qualifying as renewable. Many US staterenewable electricity programs have excluded largehydropower, a decision that United States andCanada have long disputed (Rowlands 2009).Ontario’s feed-in tariffs for renewable electricity areconditioned upon a domestic content requirement of25 percent for wind turbines and 50 percent for solarpanels. This provision has been challenged in WTOdispute settlement by Japan, the United States, andthe European Union. Some states also have require-

ments that are transparently engineered to favor

locally important industries; an example is North

Carolina, which requires utilities to generate a certain

percentage of electricity from swine and poultry waste

(Fickling 2010).

Conclusion and policy recommendations

While coordinated federal legislation in the United

States, Canada and Mexico would be ideal, this paper

offers some modest steps that the two countries could

take to coordinate state initiatives. The CEC could

function as a clearinghouse for climate change-related

data. With modest budgetary increments, this institu-

tion could play a significant role in NAFTA climate

change initiatives by expanding its database on North

American emissions and reporting on new climate ini-

tiatives and regulations in each country. In so doing,

the CEC could become a North American clearing-

house for monitoring, reporting, and verification

(MRV) of carbon credits issued under provincial or

regional carbon regimes, which could lower transac-

tion costs of offset projects among the three North

American countries. The scope of the NADB could

also be expanded to include more projects related to

clean energy and energy efficiency.

States and provinces are already discussing the possi-

bility of mutual recognition of carbon credits gener-

ated by various regional cap-and-trade schemes, and

they should continue to study options for coordinat-

ing or integrating these evolving carbon regimes.

Policy coordination could facilitate carbon credit

trading by ensuring that carbon credits in all jurisdic-

tions represent similar kinds of carbon reductions. In

addition, greater coordination among carbon trading

regimes could help address concerns regarding ‘car-

bon leakage’ that have plagued the implementation of

cap-and-trade programs in many states.

Somewhat more controversially, states and provinces

may work toward coordinated renewable electricity

policies. All parties should agree on how imported

electricity should be credited and certified under

renewable portfolio standards, both at the federal and

state levels. To the extent feasible, states and provinces

should harmonize definitions of renewable electricity

in order to stimulate development by increasing the

fungibility of RECs. Harmonization and expansion

of renewable energy credit tracking systems could

also widen the geographic area from which renewable

credits could be purchased.

CESifo Forum 4/2010 50

Focus

8 See Energy Information Administration (2010) and letter fromCanadian Ambassador Michael Wilson to Mary Nichols,14 November 2008 (http://www.canadainternational.gc.ca/washing-ton/events-evenements/LCFS_Nichols.aspx?lang=eng.).

Page 53: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201051

Focus

The North American countries should shield climatechange taxes and regulations from claims under theindirect takings provisions of NAFTA Chapter 11.Chapter 11 requires governments to provide com-pensation to investors for measures that are ‘tanta-mount to expropriation’. To date, Chapter 11 caseshave assumed a limited scope for environmentallaws’ constituting expropriation. Climate changelaws will most likely have much broader economiceffects than prior environmental legislation, and thescope of potential claims under NAFTA Chapter 11due to climate change laws and regulations could beorders of magnitude greater than those filed in thepast. The potential for such Chapter 11 litigationagainst climate change laws could slow the imple-mentation of measures designed to mitigate GHGemissions and adversely flows of trade and invest-ment in the region.

These measures would increase the efficiency of stateand regional climate change regulations. However,they are no substitute for a comprehensive nationalapproach to climate change in both countries. Inorder to ensure the best policy outcome, Obama andHarper should work toward a national cap-and-tradeor carbon tax bill.

References

Bianco, N. and F. Litz (2010), Reducing Greenhouse Gas Emissions inthe United States Using Existing Federal Authorities and State Action,Washington DC: World Resources Institute.

Centro Mario Molina (2008), Low Carbon Growth: A Potential Pathfor Mexico, Discussion Draft presented at Poznan Climate ChangeConference, Poznan, 1–12 December.

Department of Energy (2008), 20 Percent Wind Energy by 2030:Increasing Wind Energy’s Contribution to US Electricity Supply,http://www.osti.gov/bridge.

Energy Information Administration (2010), Crude Oil and TotalPetroleum Imports Top 15 Countries, http://www.eia.doe.gov.

Fickling, M. (2010), US and Canadian Climate Legislation by Stateand Province, Washington DC: Peterson Institute for InternationalEconomics.

Fickling, M. and J.J. Schott (2011), NAFTA and Climate Change.Washington DC: Peterson Institute for International Economics,forthcoming.

Hufbauer, G. and J. Kim (2009), U.S. Climate Legislation Impli-cations and Prospects: Challenges for Canada, Conference Board ofCanada, http://www.conferenceboard.ca/documents. aspx?did=3300.

Hufbauer, G. and J.J. Schott (2005), NAFTA Revisited, WashingtonDC: Peterson Institute for International Economics.

Kass, S.L. and J. McCarroll (2008), Environmental Enforcement andProtection under NAFTA, New York Law Journal,http://www.clm.com/publication.cfm/ID/191.

North American Development Bank (NADB, 2010), QuarterlyStatus Report, http://www.nadbank.org/pdfs/status_eng.pdf.

RGGI Emissions Leakage Multi-State Staff Working Group (RGGI,2007), Potential Emissions Leakage and the Regional Greenhouse GasInitiative (RGGI): Evaluating Market Dynamics, Monitoring Options,and Possible Mitigation Mechanisms,http://rggi.org/docs/il_report_final_3_14_07.pdf.

Richardson, N., A.G. Fraas and D. Burtraw (2010), Greenhouse Gas Regulation under the Clean Air Act: Structure, Effects, and Impli-cations of a Knowable Pathway, RFF Discussion Paper 10-23,http://www.rff.org.

Rowlands, I.H. (2009), “Renewable Electricity Politics acrossBorders”, in: Selin H. and S.D. VanDeveer (eds.), Changing Climatesin North American Politics: Institutions, Policymaking, and MultilevelGovernance, Cambridge MA: MIT Press, 181–198.

Schott, J.J. and M. Fickling (2009), Setting the NAFTA Agenda onClimate Change, Policy Brief 09-18, Washington DC: PetersonInstitute for International Economics.

Toman, M. et al. (2008), Unconventional Fossil-Based Fuels: Eco-nomic and Environmental Trade-Offs, RAND Corporation,http://www.rand.org/pubs/technical_reports/TR580/.

UNFCCC (2010a), Submission of Canada to the Copenhagen Accord,http://unfccc.int/files/meetings/application/pdf/canadacphaccord_app1.pdf.

UNFCCC (2010b), Mexico, National Mitigation Actions Submitted tothe Copenhagen Accord, 31 January 2010, http://unfccc.int/files/meet-ings/application/pdf/mexicocphaccord_app2.pdf.

Western Climate Initiative (WCI, 2008), Design Recommendations forthe WCI Regional Cap-and-Trade Program, http://www.westerncli-mateinitiative.org/component/remository/func-startdown/18/.

Page 54: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 52

Special

TURBULENT WATERS IN THE

EMU: TRANSLATION FROM

WIRTSCHAFTSWOCHE

KARL OTTO PÖHL*

In September 2010 the German business weekly,WirtschaftsWoche, interviewed Mr. Pöhl on old andnew conflicts in the European Monetary Union, thefuture of the euro and necessary structure reforms forthe ECB and the Bundesbank.

WirtschaftsWoche: Mr. Pöhl, the Bundesbank is caught

up in difficult times. How did you react to the recent

debate over Mr. Sarrazin, and what lessons should we

learn from it?

I do not want to comment on this issue in detail, but itwould surely make sense to change the Bundesbankstatute. One should give thought to reforming the proce-dures for appointments to the executive board. As it nowstands it is too federalist. The influence of the federalstates on appointments to the executive board has his-torical reasons that are no longer valid today. What tiesdoes the Bundesbank still have with the federal states?My suggestion would be that only the federal govern-ment make appointments to the executive board, and itshould include the Bundesbank in this decision making.

Another important issue is the European Monetary

Union. How do you evaluate the current debt crisis of

the euro countries?

I put no stock in the rescue programme for the euroarea. It gives the countries the wrong incentives andviolates the spirit and letter of the monetary union.We never wanted a transfer union – but now we arecaught up in one. The rescue programme is, after all,a traditional French position. Already in 1979 Francewanted a common European fund. ChancellorSchmidt supported President Giscard d’Estaing onthis matter. Then the wish was to stabilise theexchange rates in the European Monetary System

(EMS). The idea was that the member states could

borrow money from the fund with relative ease. Italy,

for example, would have been able to take out a loan

in deutschmarks and pay it back in lira. That would

have been a real inflation machine. The Bundesbank

was strictly opposed to this at the time, and a strong

confrontation with the federal government was the

result. Helmut Schmidt even threatened us with a

reform of the Bundesbank statute to deprive us of our

power. However, in the end we prevailed and the fund

did not come about. This time the French managed to

get their idea through, which could prove to be very

expensive for us. If countries such as Greece, Portugal

or Ireland do in fact make use of the rescue pro-

gramme, it will become prohibitively expensive.

Would there have been other options in your opinion?

Of course. Greece should never have been accepted

into the monetary union. But it was. Now it must be

possible to leave the union. Then, a haircut should

have been carried out (partial debt forgiveness by the

creditors), the Greeks would have devalued in order to

improve their competitiveness. But Mr. Sarkozy was

no doubt fearful of the French banks, which were

strongly committed in Greece.

Apart from the problem of technical feasibility – would-

n’t that have resulted in incredible turbulence?

That’s what many say, but I’m not so sure. There

might have been the risk of the monetary union col-

lapsing, but the risk was much smaller than most

believed. Greece is not really that important after all.

The core countries would have remained in the euro

area. I do not believe that there would have been

major deformations.

ECB President Jean-Claude Trichet has said again and

again that the Europeans are bound together by fate.

You were involved – as he is – in the process of Euro-

pean unification for many decades. Do Europeans share

a common fate?

We are indeed a community. But I do not see things

as dramatically as Mr. Trichet does. I have known* Former Bundesbank President.

Page 55: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201053

Special

him for decades, he is an honest man, and he would

never act against his convictions. It was certainly a

difficult situation at the beginning of May, when the

decision was made on the rescue programme. But I

don’t believe that Europe itself was threatened

because of Greece. The ECB unfortunately has

moved into turbulent waters by throwing major prin-

ciples overboard. It is now purchasing government

bonds from euro countries and is thus weakening its

independence.

Can this we undone?

In my opinion it is irreversible. They can’t ‘do this’ one

minute and ‘do that’ the next. The bond purchases

and the rescue programme are a breach of the

Maastricht Treaty by mutual agreement. Of course it

was an emergency, but now it has also become a

precedent, and that is the great danger.

Now the situation on the financial markets has sta-

bilised somewhat and the euro is also on the road to

recovery ...

… which is still no justification for throwing your

principles overboard.

What can the ECB do to restore its credibility?

One possibility would be to make Axel Weber its

president in autumn next year. Mr. Weber stands

for stability policies that the Bundesbank still holds

high. It would be even more important, however, to

change the ECB statutes. At the beginning of the

1990s when we drafted the statutes, I strongly

favoured the principle of ‘one country one vote’.

That surprised many at the time. Weighting the

votes of a country according to economic strength

or population size, for example, would not have

succeeded politically. But the times have now

changed. Then I would not have considered it pos-

sible that countries such as Malta and Cyprus

would be included in the euro. I thought it would be

limited to the six founding members. Now the mon-

etary union has became larger than we originally

believed. And therefore the principle of ‘one coun-

try one vote’ is no longer in keeping with the times.

It is not acceptable for the central banks of Malta

or Cyprus to have the same voting power in the

ECB as the Bundesbank. This waters down the

decisions of the European Central Bank. Voting

rights in the ECB should be changed and weighted

votes should be assigned according to the strength

of the countries. This would help the ECB manage

future crises more convincingly.

Will there still be the euro in ten years?

I believe so, yes. The euro is irreversible. Perhaps there

will be a different euro, perhaps limited to fewer coun-

tries. This I consider possible and it would also be

desirable. But it will not cease to exist.

There is always tension between monetary policy and

government policy, as was the case during German

reunification. At the time, as President of the

Bundesbank, you spoke out against an immediate

German monetary union. How do you see this now –

20 years later?

The main issue at the time was the D-mark/GDR-

mark exchange rate. The experts at the time agreed

that a 1:1 exchange rate would be false economi-

cally. The correct rate would have been perhaps

three eastern marks to one D-mark. But this was

unacceptable for Mr. Kohl and Mr. Waigel. They

wanted to push through the monetary union and

simply overruled me and the Bundesbank. This

was one of the reasons I resigned, since it was a

policy I couldn’t support. Today I realise that there

had been enormous pressure. The east German

population wanted to finally have the prosperity

they had been dreaming about for decades. Just

imagine that wages in the east, with an exchange

rate of 3:1, would have fallen by around two thirds

– there would have been a popular uprising. In this

respect political reality was stronger than econom-

ic logic.

Looking back on your career, you came a long way from

a convinced social democrat to a market liberal ...

I have always been a liberal. Karl Schiller was my

great model at the SPD, and he was in fact a liberal.

That was certainly possible in the SPD of the 1970s

in the social-liberal coalition. The liberals (FDP)

had Otto Graf Lambsdorff, who was a friend of

mine. I always worked closely with Mr. Lambsdorff

and Mr. Genscher, much more so than with some

SPD ministers.

The liberal wing of the SPD does not exist anymore, at

least not since Wolfgang Clement’s withdrawal ...

… which is why I also left the party in 2005. I could

no longer identify with the course of the SPD.

Page 56: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 54

Special

With the policies of Mr. Beck and now Mr. Gabriel

and Ms. Nahles, it will never win another election.

The SPD is out of touch, its programme is no

longer in accord with the times. It should be more

open economically; it should take a stand on glob-

alization and international competition. But it has-

n’t done that.

Let’s go back again to the 1980s. This was also the time

that the course was laid out for the euro in the context

of European integration ...

Correct. Helmut Schmidt and Giscard d’Estaing had

just set up the European Monetary System (EMS),

which called for fixed exchange rates between the

countries of the European Community. However, it

was a difficult birth. In the 1980s there were eleven

realignments in the EMS that is re-evaluations of the

exchange rates. In spite of these setbacks, integration

made further progress. The Single Market and the

Schengen Agreement were realised. This was backed

by the insight and political will that Europe can be

only be advanced as a joint effort. It’s like riding a

bike – you have to keep on pedalling because if you

stop you fall over.

At the time there were also financial crises ...

I remember there always being crises, since my

involvement in government. My first day in the

Chancellor’s office in 1970 began with Karl Schiller

freeing the Bundesbank of its intervention obligation

vis-à-vis the dollar. I almost had a stroke. I had to

explain to Willy Brandt why that was necessary. Then

came the European ‘currency snake’, the forerunner

of EMS. It failed because there was always someone

who couldn’t maintain the exchange rate parity. Then

came the EWS with its eleven revaluations. And in

1992, when Mr. Soros was speculating against the

pound, the British unfortunately had to leave. There

was always some crisis.

Is the current financial crisis fundamentally different?

This crisis has a new quality – only because of its

dimensions. This is due to increasing globalisation.

The states depend so strongly on each other that

undesirable developments are expanded exponential-

ly. Fluctuations become greater. This crisis also accel-

erates the shifts in the international balance of power.

China and India have increased their weight in world

politics. The United States with its gigantic mountain

of debt has been weakened.

You studied economics in the 1950s. Then John

Maynard Keynes was the guru of the economists. Are

we experiencing his comeback in the financial and eco-

nomic crisis?

I don’t think that the return to Keynesianism in eco-nomic policy will be permanent. At least not to thesimple state dirigisme of his time. Just image, in myfinal examination at the University of Göttingen in1955 I defended the thesis that the amount of indebt-edness is limited by tax revenue. I was given the grade‘good’ for this (laughs). Today of course I would notput it that way – and John Maynard Keynes probablywouldn’t either.

Page 57: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201055

Special

GREENSPAN, DODD-FRANK

AND STOCHASTIC OPTIMAL

CONTROL

JEROME L. STEIN*

Dodd-Frank financial reform bill

The Dodd-Frank (D-F) bill establishes the FinancialServices Oversight Council. The bill authorizes theFederal Reserve Board to act as agent for the Councilto monitor the financial services marketplace to iden-tify potential threats to the stability of the US finan-cial system and to identify global trends and develop-ments that could pose systemic risks to the stability ofthe US economy and to other economies.

Is the Fed capable of fulfilling these requirements?Shojai and Feiger (2010), in their article Economists’

Hubris – The Case for Risk Management – write thatthe tools that are currently at the disposal of theworld’s major global financial institutions are notadequate to help them prevent such crises in thefuture and that the current structure of these institu-tions makes it literally impossible to avoid the kind offailures that we have witnessed. I evaluate whatGreenspan has learned and develop the StochasticOptimal Control approach that should be used toimplement the D-F bill.

Greenspan’s retrospective

Greenspan’s paper (2010) presents his retrospectiveview of the crisis. His theme has several parts. First,the decline and convergence of world real long-terminterest rates – not Federal Reserve monetary policy –led to significant housing price appreciation, a hous-ing price bubble. Second, this bubble was leveraged bydebt. There was a heavy securitization of subprimemortgages. In the years leading to the current crisis,financial intermediation tried to function on too thin

layer of capital – high leverage – owing to a misread-

ing of the degree of risk embodied in ever more com-

plex financial products and markets. Third, when the

bubble unraveled, the leveraging set off a series of

defaults. Fourth, the breakdown of the bubble was

unpredictable and inevitable, given the ‘excessive’

leverage – or unduly low capital – of the financial

intermediaries.

Prior to the subprime crisis of 2007, there was a false

sense of safety in financial markets. Alan Greenspan

said in 2004 that “the surge in mortgage re-financings

likely improved rather than worsened the financial

condition of the average homeowner”. Moreover

“overall, the household sector seems to be in good

shape, and much of the apparent increase in the

household sector’s debt ratios in the past decade

reflects factors that do not suggest increasing house-

hold financial stress” (Greenspan 2004a and 2004b).

The market and the Fed did not consider these mort-

gages to be very risky. By 2007 a measure of risk, the

yield spread (CCC bonds – 10 year US Treasury), fell

to a record low.

When the crisis came in 2008, Greenspan said: “those

of us who have looked to the self-interest of lending

institutions to protect stockholders’ equity, myself

included, are in a state of disbelief”. The lesson for the

future that he has learned is that it is imperative that

there must be an increase in regulatory capital and liq-

uidity requirements by banks (Greenspan 2010).

My basic questions are: what is an optimal leverage or

capital requirement that balances the expected growth

against risk? What are theoretically founded – not ad

hoc empirical – early warning signals of a crisis? I

explain why the application of stochastic optimal con-

trol (SOC) is the effective approach to determine the

optimal degree of leverage, the optimum and exces-

sive risk and the probability of a debt crisis.

I show that the theoretically derived early warning sig-

nal (EWS) of a crisis is the excess debt ratio, equal to

the difference between the actual and optimal ratio.

The excess debt of households starting from

2004–2005 indicated that a housing crisis was most* Brown University, Providence. I thank Peter Clark and ShlomoMaital for excellent suggestions.

Page 58: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

likely. This SOC analysis should be used by those

charged with surveillance of financial markets. It is

hoped that the Fed will not be like the ancien régime:

“Ils n’ont rien appris, ni rien oublié”.

Stochastic optimal control (SOC)/dynamic risk management

The financial crisis was precipitated by the mortgage

crisis and spread through the financial sector due to

high leverage. I focus upon the housing sector, which

was has been at the origin of the crisis. At the begin-

ning of the financial chain are the mortgagors/debtors

who borrow from financial intermediaries – banks,

hedge funds, government sponsored enterprises. The

latter are creditors of the mortgagors, but ultimately

are debtors to banks or to institutional investors at

the other end. For example, the Federal National

Mortgage Association (FNMA) borrows in the world

bond market and uses the funds to purchase or later

resell packages of mortgages. If the mortgagors fail to

meet their debt payments, the effects are felt all along

the line. The stability of the financial intermediaries

and the value of the traded derivatives – CDO and

CDS – ultimately depend upon the ability of the

mortgagors to service their debts. When the mort-

gagors default, the whole leveraged financial structure

collapses.

SOC is dynamic optimization where key variables are

stochastic. A sketch of the SOC approach will facili-

tate understanding the analysis below. Technical

mathematical details are in my recent papers (Stein

2010 and 2011). The criterion/object is to maximize

the expected logarithm of household net worth at a

future date. This is a risk-averse strategy because the

logarithm is a concave function. Declines in net worth

are weighted more heavily than increases in net worth.

In fact very severe penalties are placed upon bank-

ruptcy – a zero net worth. This criterion is the growth

variable that will optimally balance expected growth

and risk.

The growth of net worth is affected by leverage. An

increase in debt to finance the purchase of assets

increases net worth by the return on investment, but

decreases the growth of net worth by the associated

interest payments. The return on investment has two

components. The first is the productivity of assets and

the second is the capital gain on the assets. An increase

in leverage will increase expected growth if the return

on investment exceeds the interest rate. The produc-

tivity of assets is observed, but the future capital gain

and the interest rates are unknown when the invest-

ment decision is made. The true stochastic process is

unknown. One must specify the stochastic process on

the capital gain and interest rate if one wants to select

the optimal leverage – to maximize the expected loga-

rithm of future net worth.

The SOC approach derives an optimal debt ratio con-

ditional upon the stochastic processes. Alternative

stochastic processes imply different optimal debt

ratios. My standard of optimality is based upon sus-

tainable stochastic processes concerning the capital

gain and interest rate. By contrast, the market opti-

mized on the basis of unsustainable stochastic

processes, which led to the bubble and its subsequent

collapse.

A sustainable stochastic process is as follows. Call this

the Prototype Model. Reasonable variations imply

similar qualitative but not quantitative results. The

capital gain is the sum of two terms: a constant drift

and a Brownian motion term. The interest rate has a

similar structure: a constant drift plus a Brownian

motion term. The capital gain and interest rate are

negatively correlated. The drift of the capital gain is

constrained not to exceed the drift of the interest rate,

to preclude the ‘free lunch’ described below.

Given the stochastic process, an optimal leverage or

capital requirement is derived as follows. The expect-

ed growth of net worth is a concave function of the

leverage. It is maximal when the optimal leverage is

chosen. As the leverage exceeds the derived optimal,

the expected growth declines and the variance/risk

rises. If the debt ratio is less than the optimal, expect-

ed growth is unduly sacrificed to reduce risk. Leverage

is equal to one plus the debt ratio; and the capital

requirement is the inverse of the leverage. I focus

upon the debt ratio, and the other ratios follow.

The main theoretical results are as follows. (1) The

optimal debt ratio is not a number, but a function. It

is proportional to: the drift of the capital gain less the

drift of the rate of interest plus the current productiv-

ity of capital less a risk premium. The factor of pro-

portionality is the reciprocal of risk elements.

Therefore the optimal debt ratio or capital require-

ment will vary among sectors and over time. One size

does not fit all. (2) Define the excess debt as the actu-

al debt ratio less the optimal ratio. For a sufficiently

high excess debt, the expected growth is zero or nega-

tive and the variance is high. The probability of a

CESifo Forum 4/2010 56

Special

Page 59: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201057

Special

decline in net worth or a debt crisis is directly related

to the excess debt ratio.

The market selected a debt ratio based upon an illu-

sion of a ‘free lunch’ – an unsustainable stochastic

process. The market estimated the drift of capital

gains on the basis of recent price changes. The recent

capital gains exceeded the interest rate so that the

mortgagors thought that they were getting a free

lunch. The rises in housing prices and in owner equi-

ty induced a demand for mortgages by banks and

funds. The mortgagors borrowed at an interest rate

below the capital gain. In about 45-55 percent of the

cases, the purpose of the subprime mortgage taken

out in 2006 was to extract cash by refinancing an

existing mortgage loan into a larger mortgage loan.

They expected to repay the loan plus interest from the

higher value of the home, due to the capital gain. The

quality of loans declined. The share of loans with full

documentation substantially decreased from 69 per-

cent in 2001 to 45 percent in 2006 (see Demyanyk and

Van Hemert 2007). The ratio of debt/income rose

drastically. The only way to service or refinance the

debt was for the capital gain to exceed the interest

rate. This is an unsustainable situation since it implies

that there is a ‘free lunch’ or that the present value of

the asset diverges to infinity.

Is the Fed capable of implementing the D-F bill? The

Fed, IMF, Treasury and the ‘Quants’/market lacked

the appropriate tools of analysis to answer the follow-

ing questions: what is an optimal leverage or capital

requirement that balances the expected growth against

risk? On the basis of the SOC analysis, I derive the

Early Warning Signals of the crisis. The excess debt

starting from 2004–2005 indicated that a crisis was

most likely. This SOC analysis should be used by those

charged with surveillance of financial markets.

The basic equations: Prototype Model

The formal structure of the Prototype Model is the

subject of this part. The reader is referred to Stein

(2010 and 2011) and to Fleming and Stein (2004) for

the mathematical details. The empirical implications

for an EWS are in the later sections.

Criterion function

As my criterion of performance, I consider maximiz-

ing the expected logarithm of net worth of the mort-

gagors. I focus upon the net worth of the mortgagors

for two reasons. First, the entire structure of the

derivatives rested upon the ability of the mortgagors

to repay their debts. Hence I ask what the optimal

debt ratio of the mortgagors is. Second, I derive an

Early Warning Signal (EWS) that a bubble, the hous-

ing price bubble, is likely to collapse.

Let W(X,T) be the expected logarithm of net worth

X(T) at time T relative to its initial value X(0). The

stochastic optimal control problem is to select debt

ratios f(t) = L(t)/X(t) during the period (0,T) that

will maximize W(T) in equation (1). The maximum

value is W*(X,T). The optimal debt/net worth

ratio f*(t) plus one is the optimal leverage, and will

vary over time. The solution of the stochastic opti-

mal control/dynamic risk management problem

tells us what an optimal and what an ‘excessive’

leverage is.

(1) W*(X,T) = maxf E ln [X(T)/X(0)],

f = L/X = debt/net worth; leverage = assets/net

worth = 1 + f

The logarithm ln(X) is a concave function of X(T). As

the expectation E[X(T)] goes to zero, the logarithm ln

[E(X(T)] goes to minus infinity. Therefore the expec-

tation E[ln X(T)] would go to minus infinity as

E[X(T)] goes to zero. Low values of net worth close to

zero may not be likely, but they have large negative

utility weights. Hence the criterion function reflects

strong risk aversion. Bankruptcy X = 0 is severely

penalized.

Dynamics of net worth

The mortgagors have a net worth X(t) equal to the

value of assets A(t) less debt L(t), see equation (2).

The value of assets A(t) = P(t)Q(t) is the product of a

deterministic physical quantity Q(t), for example an

index of the ‘quantity’ of housing, times the stochas-

tic price P(t) of the capital asset which is the housing

price index.

(2) X(t) = A(t) – L(t) = P(t)Q(t) – L(t), while

A(t) = P(t)Q(t).

The control variable is the debt ratio. The next steps

are to explain the stochastic differential equation for

net worth, relate it to the debt ratio, and specify what

are the sources and characteristics of the risk and

uncertainty.

Page 60: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

In view of equations (1) and (2), focus upon the

change in net worth dX(t) of the mortgagors. It is

the equal to the change in the value of assets dA(t)

less the change in debt dL(t). The change in the

value of assets dA(t) = d(P(t)Q(t)) shown in equa-

tion (3) has two components. The first is the change

due to the change in price of capital asset, which is

the capital gain or loss term, A(t)(dP(t)/P(t)). The

second is investment in housing I(t) = P(t) dQ(t),

the change in the quantity times the price.

(3) dA(t) = d(P(t)Q(t)) = Q(t)dP(t) + P(t)dQ(t) =

A(t)dP(t)/P(t) + I(t)

The change in debt dL(t), equation (4), is the sum

of expenditures less income. Expenditures are the

debt service i(t)L(t) at interest rate i(t), plus invest-

ment I(t) = P(t) dQ(t) plus C(t) the sum of con-

sumption, dividends and distributed profits.

Income Y(t) = ß(t)A(t) is the product of assets A(t)

times its productivity. Variable ß(t) corresponds to

the imputed rental income from housing divided by

the value of housing. This equation can be

expressed as (4a) where saving S(t) = ß(t)A(t) – C(t)

and investment is I(t). Thus the change in debt is

the sum of interest payments plus investment less

saving.

(4) dL(t) = i(t)L(t) + P(t)dQ(t) + C(t) – ß(t)A(t).

(4a) dL(t) = i(t)L(t) + I(t) – S(t).

Combining these effects, the change in net worth

dX(t) = dA(t) – dL(t) can be shown

(5) dX(t) = dA(t) – dL(t) = A(t)[dP(t)/ P(t) + ß(t) dt]

– i(t)L(t) – C(t) dt.

Since net worth is the value of assets less debt, equa-

tion (6) describes the dynamics of net worth equation

(5) in terms of the ratio f(t) = L(t)/X(t) of debt/ net

worth and an arbitrary consumption ratio c(t) =

C(t)/X(t) ≥ 0. Since leverage A(t)/X(t) = (1+f(t)), the

control variable could be either f(t) the debt ratio or

the leverage.

(6) dX(t) = X(t) {(1 + f(t)) [dP(t)/P(t) + ß(t) dt] –

i(t) f(t) – c(t) dt}.

The mortgagors borrow at interest rate i(t) and bene-

fit from the capital gain dP(t)/P(t). Both variables are

stochastic/unpredictable. What is the optimum debt

ratio, leverage or capital requirement?

The optimization of equation (1) subject to equation

(6) depends upon the stochastic processes underlying

the capital gain dP(t)/P(t), productivity of capital ß(t)

and interest rate i(t) variables. The productivity of

capital ß(t) is deterministic and observable but

changes over time. However the change in price dP(t)

from t to t+dt and future interest rates are unpre-

dictable, given all the information through present

time t. The derived optimal debt ratio, leverage or

capital requirement will depend upon the specifica-

tion of the stochastic processes of the capital gain and

interest rate.

Optimization in the Prototype Model

The Prototype Model that I use for optimization

describes the stochastic process of the capital gain as

equation (7) and the interest rate as equation (8). The

capital gain dP(t)/P(t) has a constant drift or mean

π dt and a diffusion or stochastic term σpdwp. The

expectation of the stochastic term is zero and its vari-

ance is σp2dt. Similarly the interest rate has a mean or

expectation of i dt and a variance of σi2dt. The corre-

lation between the capital gain and interest rate is

E(dwpdwi) = ρ dt, 1 ≥ ρ ≥ –1.

(7) dP(t)/P(t) = π dt + σp dwp.

(8) i(t) = i dt + σidwi

E dwp = E dwi = 0, E(dwi2) = dt, E (dwp2) = dt,

E(dwidwp) = ρ dt.

The maximization of expected net worth, equation

(1), subject to the stochastic processes, equations

(6)–(8), implies equation (9) for f*(t) the optimal ratio

of debt/net worth. Since leverage is equal to one plus

the debt ratio and capital requirement is the recipro-

cal of leverage, equation (9) is the key theoretical

result:

(9) f*(t) =[[(π + ß(t) – i) – (σp2 – ρσiσp)]/[σp2 + σi2 –

2 ρσiσp] ≥ 0.

The economic meaning and implications of f*(t)

are explained in the next part. An empirically use-

ful upper bound on the optimal debt ratio in the pro-

totype model f**(t) occurs when the two distur-

bances are independent and the drift of the capital

gain is equal to that of the interest rate, equations

(9a) and (9b):

(9a) f*(t) < [(ß(t) – σp2]/[σp2 + σi2] ≥ 0.

CESifo Forum 4/2010 58

Special

Page 61: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201059

Special

(9b) f**(t) = [(ß(t) – σp2]/[σp2 + σi2]

The ‘fundamentals’ that determine the optimal debtratio f*, leverage (1+f*) or capital requirements1/(1+f*) are in the right hand side of equation (9).

Economic implications of the optimum debtratio/leverage/capital requirements in the PrototypeModel

There are several important implications of equation(9). First, the optimum debt ratio f*(t) is proportion-al to the expected return (π + ß(t) – i) less a risk pre-mium (σp2 – ρσiσp), where the factor of proportional-ity is 1/[σp2 + σi2 – 2 ρσiσp], the risk elements. Optimalleverage and capital requirements follow. Second, debtwill only be optimal if the expected return exceeds therisk premium. Third, define excess debt Ψ(t) = f(t) –f*(t) as the difference between the actual debt ratio f(t)and the optimal f*(t). As the debt ratio exceeds theoptimum f*(t) there is an ‘excess debt’ and the expect-ed growth declines. For sufficiently high debt ratio f-max, the expected growth is zero. A warning signal

that too much risk has been undertaken is that theexcess debt Ψ(t) = f(t) – f*(t) is large. Alternatively,leverage is excessive when the debt ratio exceeds f*(t).The probability of a crash increases with the excessdebt, and is very likely when f(t) > f-max. The capitalrequirement A/X = 1/[1+f(t)] is optimal when f(t) =

f*(t) and is too low for debt ratios above f*(t). This isgeneral formulation that can be applied to any sector.Equations (9) or (10) imply the optimal capitalrequirement X*(t)/A(t).

Application to housing sector: estimates of excess debtas an early warning signal of a crisis

The financial crisis was precipitated by the mortgagecrisis. First, from 1995–2005 the decline in the 30-yearfixed rate mortgage interest rates (Figure 1) led to cap-ital gains CAPGAIN (Figure 2). Second, the mort-gagors and the financial intermediaries deluded them-selves in thinking that the mean of the capital gain –based upon the recent price experience – could con-tinue to exceed the mean of the interest rate. Hencethe market thought that the ‘optimum’ debt ratio,based upon π – i > 0, exceeded f**(t) in equation (9b).They thought that the ‘free lunch’ could continue.Third, a whole structure of financial derivatives wasbased upon the ultimate debtors – the mortgagors.Fourth, the financial intermediaries, whose assets andliabilities were based upon the value of derivatives,were very highly leveraged. Percentage changes in thevalues of their net worth were large multiples of per-centage changes in asset values. Fifth, the financialintermediaries were closely linked – the assets of onegroup were liabilities of another. The whole structureof derivatives rested upon the mortgagors being able

Figure 1THIRTY-YEAR CONVENTIONAL MORTGAGE RATE IN THE US

Source: Board of Governors of the Federal Reserve System.

Page 62: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

to service their debts. Sixth, the collapse occurredwhen the capital gain fell below the rate of interest:the ‘free lunch’ was over. Defaults and bankruptciesoccurred. A cascade was precipitated by the mortgagedefaults.

The application of the Prototype Model/SOC analy-sis is done in several steps. First, on the basis of theanalysis, I derive estimates of the excess debt Ψ(t) = f(t) – f*(t) that lowered the expected returnand raised risk. Early warning signals (EWS) arethereby derived. An Early Warning Signal of a debtcrisis is a series of excessive debts Ψ(t) = f(t) – f*(t)> 0. When the debt ratio f(t) exceeds f-max, theexpected growth is negative and the risk is high. Thenext question is: what are the appropriate measuresof the actual and the optimal debt ratio to evaluateexcess debt Ψ(t)?

The debt ratio that I use in empirical work is the ratioof household debt as a percent of disposable income,since I do not have estimates of household net worth.In order to make alterative measures of the debt ratioand key economic variables comparable, I use nor-malized variables where the normalization (N) of avariable Z(t) called N(Z) = [Z(t) – mean Z]/standarddeviation. The mean of N(Z) is zero and its standarddeviation is unity. The normalized debt ratio is equa-tion (10) and is graphed in Figure 3:

(10) DEBTRATIO = N[f(t)] = [debt/disposable income – mean]/standard deviation.

One cannot be sure what the correct stochasticprocesses on the capital gain and interest rate are.Therefore there is ambiguity concerning the exact

value of the optimal debt ratiof*(t). For this reason I work withf**(t) which is an upper bound ofthe optimum debt ratio basedupon equation (9b). A justifica-tion is as follows. In the case ofthe housing sector, historicallythe mean capital gain 1980–2007was π = 5.4 percent, with a stan-dard deviation of 2.9 percent.The 30-year conventional mort-gage rate of interest from 1998 to2007 ranged between 7.5 percentand 6 percent. If we assume thatthe difference (π – i) between themean interest rate and the meancapital gain is not significant, and

the correlation ρ = 0, then an upper bound of the opti-mal debt ratio f** for the housing sector is (9b). Thisformulation is qualitatively, but not quantitatively,consistent with alternative theoretical measures of theoptimum debt ratio implied by alternative stochasticprocesses.

(9b) f** = L*/X = [ß(t) – σp2]/[σp2 + σi2] ≥ 0.

The term [ß(t) – σp2]/[σp2 + σi2] represents the ‘funda-

mental’ determinants of the optimal debt ratio. Wemust estimate ß(t), the productivity of assets. The pro-ductivity of housing assets is the (implicit net rentalincome/value of the home) plus a convenience yield inowning one’s home. Assume that the convenienceyield in owning a home has been relatively constant.The productivity of assets ß(t) is rental income/valueassets = Y(t)/A(t) = Y(t)/Q(t)P(t), where Y(t) is rentalincome, P(t) is an index of housing prices and Q(t) isan index of the physical quantity of housing.Therefore ß(t) is proportional to a ratio of rentalincome to an index of housing prices.

(11) ß(t) ~ Y(t)/P(t)

An empirical proxy for f**(t) an upper bound ofthe optimal debt ratio is RENTPRICE defined inequation (12). Since the units of numerator anddenominator differ, it makes sense to use normal-ized variables to estimate ß(t) the productivity ofassets. The term [(ß(t) – ß)] is the deviation of thecurrent return on assets from its mean value ß overthe entire period.

In Figure 3 and equation (12) variable RENTPRICEis the normalized return, measured in units of stan-

CESifo Forum 4/2010 60

Special

0

2

4

6

8

10

12

14

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: Office of Federal Housing Enterprise Oversight (OFHEO).

%

APPRECIATION OF SINGLE-FAMILY HOUSING PRICES CAPGAIN4Q appreciation of US housing prices (HPI)

Figure 2

Page 63: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201061

Special

dard deviation from the mean ß. It is equal to the ratio of (rental income/index of housing prices –mean)/standard deviation.

(12) N(f**(t)) = [Y(t)/P(t) – mean]/st. dev. ~ [(ß(t) – ß)] / σ(ß) = RENTPRICE

Variable N(f**(t)) in equation (12) is proportional toan upper bound of the optimal debt ratio in equation(9b). Both the actual (DEBTRATIO) and optimal(RENTPRICE) are graphed in normalized form inFigure 3.

The next question is how to estimate the excess debtΨ(t). I estimate excess debt Ψ(t) = (f(t) – f**(t)) byusing the difference between two normalized variablesN(f(t)) – N(f*(t)), see equation (13). This difference ismeasured in standard deviations.

(13) Excess Debt Ψ(t) = N[f(t)] – N[f*(t)] = DEBTRATIO – RENTPRICE.

Excess Debt Ψ(t) corresponds to the difference betweenthe two curves DEBTRATIO and RENTPRICE inFigure 3. The probability of a decline in net worth ispositively related to Ψ(t) the excess debt because, as theexcess debt rises, the expected growth declines.

In the most general way, Figure 3 should be viewed asfollows. Assume that over the entire period 1980–2007the debt ratio was not excessive. Both variables arenormalized to make them comparable. When the

DEBTRATIO is above (below) its mean, the RENT-PRICE should be above (below) its mean. When thedebt ratio rose significantly above a proxy for anupper bound of the optimal debt ratio, the RENT-PRICE declined below the mean. From 1996 and by2007 it was 1.5 standard deviations below the mean.The actual debt ratio DEBTRATIO grew steadilyabove the mean from 1998, and by 2007 was 2 stan-dard deviations above the mean. Thus the excess debtgrew to 3 standard deviations above the meanfrom1998 to 2007.

The normalized actual debt ratio got out of line withthe normalized proxy for an upper bound of the opti-mal debt ratio. The latter reflects the ‘fundamentals’.The sequence of excess debts Ψ(t) is a clear measureof a bubble. The actual debt was induced by capitalgains in excess of the interest rate. The debt couldonly be serviced from capital gains. This situation isunsustainable. When the capital gains fell below theinterest rate, the debts could not be serviced fromincome. A crisis was inevitable.

The advantages of using excess debt Ψ(t) in Figure 3as an Early Warning Signal compared to just the ratioof housing price/disposable income are that Ψ(t)focuses upon the fundamental determinants of theoptimal debt ratio as well as upon the actual ratio.The probability of declines in net worth, the inabilityof the mortgagors to service their debts and the finan-cial collapse and a crisis due to leverage, are directlyrelated to the excess debt.

Conclusions

The Jackson Hole Consensus(JHC) has been the prevailingregulatory approach taken by theFed. It is based upon three prin-ciples. Central banks (i) shouldnot target asset prices; (ii) shouldnot try to prick an asset pricebubble; and (iii) should follow a‘mopping up’ strategy after thebubble bursts by injecting enoughliquidity to avoid serious effectsupon the real economy. A justifi-cation for this policy was seen inthe period 2000–2002 with thecollapse of the dot.com bubble.

Issing (2010) objects to the JHCbecause it constitutes an asym-

Notes: Excess debt Ψ(t) = N[f(t)] – N[f*(t)]; N[f(t)] = DEBTRATIO = (household debt as per-cent of disposable income – mean)/standard deviation; N[f**t)] = RENTPRICE = (rentalincome/housing price index – mean)/standard deviation.Sources: FRED, Federal Reserve Bank St. Louis; Office of Federal Housing EnterpriseOversight (OFHEO).

10

11

12

13

14

15

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

DEBTRATIO

RENTPRICE

EARLY WARNING SIGNALS

3

2

1

0

-1

-2

Figure 3

Page 64: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

metric approach. When asset prices rise without infla-tionary effects measured by the CPI, this is deemedirrelevant for monetary policy. But when the bubblebursts, central banks must come to the rescue. This, heargues, produces a moral hazard. He wrote: “did wereally need a crisis that brought the world to the brinkof a financial meltdown to learn that the philosophywhich was at the time seen as state of the art was infact dangerously flawed? We must conduct a thoroughdiscussion as to appropriate strategy of central bankswith respect to asset prices”.

Greenspan argues that the crisis was unpredictable. Itis ironic that the Fed claims that it can use the FederalFunds rate to target inflation or to stabilize the econ-omy but asserts that the financial crisis was unpre-dictable and inevitable. On the other hand, on thebasis of the SOC analysis in this paper, the sequenceexcess debts Ψ(t) from 2003 in Figure 3 was an earlywarning signal of a crisis.

The Dodd-Frank bill authorizes the Fed to performmarket surveillance. I explain why the application ofstochastic optimal control (SOC) is an effectiveapproach to determine the optimal degree of leverage,the optimum and excessive risk, the optimumrisk/expected return trade-off and EWS of the proba-bility of a debt crisis. A similar analysis was applied tothe Asian crisis in Stein (2006). This SOC analysisshould be used by those charged with surveillance offinancial markets.

References

Demyanyk, Y. and O. Van Hemert (2007), Understanding theSubprime Mortgage Crisis, Federal Reserve Bank of St. Louis Super-visory Policy Analysis Working Paper 2007–05.

Fleming, W.H. and J.L. Stein (2004), “Stochastic Optimal Control,International Finance and Debt”, Journal of Banking & Finance 28,979–996.

Greenspan, A. (2004a), Understanding Household Debt Obligations,Remarks at Credit Union National Association, Washington DC,23 February.

Greenspan, A. (2004b), The Mortgage Market and Consumer Debt,Remarks at America’s Community Bankers Annual Convention,Washington DC, 19 October.

Greenspan, A. (2008), Testimony on Sources of Financial Crisis,House Committee on Government Oversight and Reform,Washington DC, 23 October.

Greenspan, A. (2010), “The Crisis”, Brookings Papers, second draft.

Issing, O. (2010), “Some Lessons from the Financial Crisis”, Inter-national Finance 12, 431–444.

Shojai, S. and G. Feiger (2010), “Economists’ Hubris – The Case ofRisk management”, Journal Financial Transformation 28, 25–35.

Stein, J.L. (2006), Stochastic Optimal Control, International Financeand Debt Crises, New York: Oxford University Press.

Stein, J.L (2010), “Greenspan’s Retrospective of Financial Crisis andStochastic Optimal Control”, European Financial Management 16,858–871.

Stein, J.L. (2011) “The Crisis, Fed, Quants and Stochastic OptimalControl”, Journal of Economic Modelling, forthcoming.

CESifo Forum 4/2010 62

Special

Page 65: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201063

Special

ESTIMATION OF PRODUCTION

COSTS FOR ENERGY RESOURCES

HANS-DIETER KARL*

Introduction

The use of fossil fuels largely depends on the costs ofmaking these fuels available. Among these costs, theproduction expenses, which are influenced by numer-ous factors, are of prime importance. The aim of thisstudy is to determine the unit costs of productionfrom the currently used deposits and to estimate theunit costs of production from deposits that will betapped in future. An exact definition of productioncosts is exceedingly difficult to make. Therefore, theaverage production costs for mineral oil, natural gasand black coal determined in this study must be seenas approximations of reality. For the determination ofthe production costs of currently used deposits andfor the estimates of the costs of future deposits,recourse is made primarily to existing studies and esti-mates in the literature.

Energy production costs of great importance

In the present and future use of fossil energy sources,the costs of making them available play a key role,among which the production costs, which are influ-enced by numerous determinants, are crucial. In addi-tion to the geological, technical and economic factors,the political conditions of extraction are also ofmajor importance. This study seeks to determine theunit costs of production at currently used depositsand to estimate the unit costs of production fromdeposits that will be tapped in future. An exact defin-ition of production costs is very difficult for severalreasons. Since the production costs are an importantcompetitive factor for individual enterprises, they areusually not made public. In addition the costs arehighly dependent on the factors of the individualdeposits such as their location and size, and can there-

fore differ greatly. Finally, during extraction of the

raw materials additional, unanticipated expenditures

such as strikes, storms or subsequently imposed regu-

lations may occur so that the actual production costs

can often only be precisely determined after the fact.

In the following the production costs for the domi-

nant fossil energy sources – mineral oil, natural gas

and black coal – will be identified. These costs include

the costs for the extraction of the energy resources, i.e.

for the operation of the extraction facilities (especial-

ly wage and intermediate material costs) and the cap-

ital costs allocated to the service life of the facility,

which result from the expenditures for the exploration

and the construction of the facilities for the extraction

of the energy sources from the site of the deposits.

Included in these capital costs are also the expendi-

tures that accrue in the course of the depletion of the

raw materials in order to counter the gradual decline

in the production output and to be able to keep

extraction at a high level. This applies especially to oil

and gas deposits, for example, by the application of

secondary and tertiary procedures to increase the

degree of exploitation.

Not included are the so-called user costs, i.e. the costs

from the loss in value of the remainder of the in-situ

resources that arise as a result of the extraction of the

resource itself, as well as the royalties that precisely

reflect these users costs if the extracted resources are

not the sole property of the extracting company.

For the determination of the production costs of the

currently used deposits, recourse is made to several

currently available studies and estimates in the litera-

ture, where the production costs are given in the form

of unit costs. The information available in the litera-

ture for various years is converted uniformly to a price

basis of 2009. The estimation of the unit costs of

deposits exploited in the future is also carried out by

means of the information in the literature and on the

basis of forecasts of the requirements for the individ-

ual energy sources in the coming decades as well as by

using estimates of the probable development of

investments for accessing new deposits or for the con-

tinuation of production.* Ifo Institute for Economic Research.

Page 66: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

Mineral oil: the dominant energy source

Mineral oil continues to be the most important

energy source worldwide. It clearly stands in first

place in terms of both consumption and traded vol-

umes. The high trading volume of mineral oil is

attributable mainly to the fact that the worldwide

concentrations of consumption and the areas with

the highest crude oil production, which frequently

have a high export potential, are at a comparably

far distance from each other. Furthermore, the

most important exporting countries are also those

with the most extensive conventional oil reserves.

At the end of 2008 the worldwide reserves amount-

ed to ca. 182 billion toe (tonnes of oil equivalent).

With an annual consumption of currently ca.

3.9 billion toe, a static range of 46 years of oil

reserves can be calculated. Of total reserves,

101 billion toe are concentrated in the Middle East,

and the annual consumption of these countries in

2008 amounted to 0.3 billion toe (ExxonMobil

2009). The leading position of mineral oil is based

on its specific advantages, especially its broad

application spectrum as well as its favourable trans-

portation and storage. Because of its overriding

importance, mineral oil is a strategic raw material.

Most analyses and forecasts of developments on

the world energy markets conclude that demand for

mineral oil will continue to increase also in the

coming years. However, smaller growth than only a

few years ago is expected, for example by the

International Energy Agency (IEA), because of the

increasing difficulties in accessing deposits and the

associated high costs.

The great number of analyses and forecasts are

understandable in light of the extraordinary impor-

tance of mineral oil. However, the great majority of

studies deal with questions of available quantities,

of the technical possibilities of extraction, price

developments and the political implications of

greater oil consumption when faced with the insecu-

rities of the supply. Studies of the costs of explo-

ration, accessing and extracting crude oil are con-

siderably less numerous. There are objective reasons

for this, especially the geological differences and the

size of the individual deposits as well as the differ-

ent technical efforts for oil extraction. In addition,

companies often treat their data on the costs of oil

production confidentially. Under these circum-

stances, the published numbers on production costs

are usually estimates of the respective authors.

Nevertheless, these estimates are probably fairly

accurate. Because of the considerable differencesbetween the oil fields, however, the production costscover a fairly wide range. This is also a result of thestrong increase in the price of oil in recent years thatmade it possible to extract oil from sites with com-paratively high extraction costs. In the following,the present and expected future production costs arepresented as a whole as well as their two compo-nents: capital costs and operating costs. The focuswill be particularly on the presentation of averagevalues.

A recent study was conducted by Deutsche Bank(Deutsche Bank 2009), containing estimates of cur-rent production costs (OPEX) for 90 percent of worldoil production without capital costs, royalties andexploration costs for 2009. For the large oil fields,which account for ca. 70 percent of worldwide pro-duction, these average costs stand at 6.20 US dol-lars/bbl (bbl = barrel; 1 bbl = 159 litres). The range ofthese costs extends from 1 US dollar/bbl in theArabian Gulf states to about 26 US dollars/bbl crudein the Canadian oil sands, the latter not being ofmuch importance in current production volume. Thedirect production costs of the smaller fields – about asixth of worldwide production – amount to 8.30 USdollars/bbl, on average. The production costs for allthe fields examined in the study, which determine thedevelopment of the worldwide oil market, average6.60 US dollars/bbl.1

For 2007, the Deutsche Bank study shows in additionthe total costs of oil production (technical costs).These costs are derived from information – also with-out royalties or user costs – of large mineral oil com-panies and display a considerable range. On average,these total costs without taxes amounted to 15.20 USdollars/bbl; they contain the direct production costs(share: approximately 39 percent), the capital costs(about 47 percent) as well as the costs for exploration(14 percent). Total costs increased in the last five yearsby an annual average of 14 percent. Since for the esti-mate of these production costs only the data of themineral oil companies were used, the calculation doesnot include the corresponding data of the national oilcompanies, which are of great importance for the oilmarket and determine, for example, the supply of theOPEC countries. It is, however, to be assumed thatmany of these national providers are able to produceat relatively low capital and exploration costs. For thisreason it can be presumed that global average produc-

CESifo Forum 4/2010 64

Special

1 The average is calculated by weighting the production costs with therespective shares of the production volume.

Page 67: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201065

Special

tion costs for 2007 were below the 15.20 US dol-

lars/bbl mentioned above.

For comparison reference is made to a study by

Dresdner Kleinwort (2006), in which also the oil pro-

duction costs of large oil companies are listed for

2005. Average production costs of these companies of

10.5 US dollars/bbl can be derived from a graph in

this study; for 2007, with the above-mentioned yearly

rate of increase, production costs of 13.5 US dol-

lars/bbl result. According to the estimates of

Dresdner Kleinwort (2006), the average production

costs of the Russian companies examined in the study

were less than half as high. These estimates are an

indication of the oft-times favourable production con-

ditions of national oil companies.

Informed by these studies, we turn to another approach

to estimating current oil production costs. The study by

Aguilera et al. (2009) calculates total production costs in

US dollar prices of 2006 for crude oil extracted in the

future. In this approach, which is based on a study by the

United States Geological Survey in 2000, the expected

costs for all relevant oil producing areas are given, and

for most of the deposits total production costs are divid-

ed into (average) capital and operating costs. An

amount-weighted assessment of these total costs showed

that 56 percent of the total costs are accounted for by the

operating costs. Taking this percentage as approximately

valid also for current production, then global operating

costs – as listed in the study of Deutsche Bank (2009) –

of 6.6 US dollars/bbl result in total production costs of

11.8 US dollars/bbl; this corresponds to a share of the

world market price for crude oil in the fourth quarter of

2009 of approximately 16 percent. This value for total oil

production costs is comparably close to the result found

in the study of Jojahrt (2008), in which for 2006 an aver-

age value of 9 US dollars/bbl was indicated (2009:

almost 11 US dollars/bbl) in a range of between 3.38 and

20.79 US dollars/bbl. The production costs estimated by

Remme, Blesl and Fahl (2007) are at about the same

level; a weighted average of ca. 8.8 US dollars/bbl in

prices of 2000 can be derived from the data of this study.

This corresponds to production costs for 2009 of nearly

11 US dollars/bbl crude oil. Altogether, average produc-

tion costs are currently approximately 11 to 12 US dol-

lars/bbl for crude oil.

Rise in oil production costs expected

For estimating the unit costs of crude oil production

from future deposits, there are different possibilities.

On the one hand, the study of Aguilera et al. (2009)

can be used directly, in which the oil still available in

the future and the additional accessible reserves are

indicated at a total of 3.561 trillion bbl; this corre-

sponds to approximately 486 billion toe and thus

almost 2.7 times the reserves that were listed by

ExxonMobil (2009) for the end of 2008. These total

reserves are comprised of the 2.713 trillion bbl from

the amounts derived from the United States

Geological Survey and 848 billion bbl from addi-

tional fields. For the production of the quantities

found in the United States Geological Survey, aver-

age costs are calculated at 6 US dollars/bbl in 2006

prices; the range of these costs extends from 1.08 US

dollars/bbl for deposits in the Arabian Gulf states to

15.27 US dollars/bbl for on- and offshore oil from

Kazakhstan. The costs for the additional oil produc-

tion quantities average 18.9 US dollars/bbl with a

range of between 15.41 US dollars/bbl in Europe

and 26.72 US dollars/bbl in Sub-Saharan Africa and

in Antarctica.

For the total amounts of oil under consideration,

average production costs at 2006 prices can be calcu-

lated amounting to approximately 9.1 US dollars/bbl.

At annual price increases of 14 percent, as listed by

Deutsche Bank (2009) for 2002 to 2007, nominal aver-

age production costs for 2007 are 10.4 US dollars/bbl.

Since the cost increases have slowed down consider-

ably, production costs for 2009 are estimated to total

11 US dollars/bbl. This appears to be comparably lit-

tle in light of the above estimated production costs at

deposits used today of 11.8 US dollars/bbl, and can

only be explained by the fact that the production costs

listed by Aguilera et al. (2009) are to be understood as

static; they include neither the technical progress that

leads to a reduction of costs over time nor do they

take cost increases, as witnessed particularly between

2006 and 2008 into consideration, since they are

regarded to a considerable extent as cyclical.

In the study by Remme, Blesl and Fahl (2007) average

weighted production costs of between 8.6 and

22.9 US dollars/bbl in prices of 2000 – or an average

of 15.8 US dollars/bbl – are calculated for oil deposits

to be tapped in the future; in prices of 2009 this

amounts to 20 US dollars/bbl. Within this range of

production costs lie the costs for the extraction from

oil sands and heavy oil deposits. The production costs

for the extraction of the oil resources, however, are

somewhat below the production costs of enhanced oil

recovery (EOR) of known deposits. Extraction from

oil shale is by far the most expensive.

Page 68: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

In addition there is also the possibility of estimatingthe unit costs of deposits to be tapped in future bymeans of the 2008 projections of the IEA.2 These pro-jections see the worldwide supply increasing from84.3 mb/d (million barrels a day) in 2007 to 94.4 mb/din 2015 and 106.4 mb/d in 2030. Via the upstreaminvestments in this period, however, not only theincreasing oil requirement must be satisfied but alsooffset with the natural decline in production of thepresently exploited deposits. The IEA assumes adecline in production of present oil wells of an aver-age of 6.7 percent per annum; this rate will increase inthe coming years and, according to the estimates ofthe IEA, will amount to ca. 10.5 percent per annum in2030. This means that, on the one hand, because ofthe decline in production of present deposits, oil wellsproducing 64 mb/d must be tapped by 2030 and, onthe other hand, because of the increase in the rate ofdecline, the production capacity must be raised by anadditional 23 mb/d. With an increase in the supply ofca. 22.1 mb/d, production capacities must be in-creased by ca. 110 mb/d by 2030. For this, the IEAestimates necessary investments of 5.036 trillion USdollars in 2007 prices; this breaks down to 4.604 tril-lion US dollars for conventional oil and 432 billionUS dollars for non-conventional oil.

Thus, in this period, 45,780 US dollars (2007) will beinvested, on average, for the creation of an addition-al production capacity of 1 b/d. Under the assump-tion of a typical service life of 25 years for an oilfield (see International Energy Agency 2010), invest-ments of 5 US dollars/bbl can be calculated. Thereare, however, considerable differences depending onthe deposits: in the Middle East investments, accord-ing to IEA information, amount to ca. 12,000 USdollars/b/d; converted to the total amount of crudeoil produced, this corresponds to ca. 1.3 US dol-lars/bbl. For oil extraction in the Gulf of Mexico,30,000 US dollars/b/d (3.3 US dollars/bbl) must becalculated, in the North Sea 40,000 US dollars/b/d(4.4 US dollars/bbl) and for the oil sands approxi-mately 70,000 US dollars/b/d (7.7 US dollars/bbl).As a comparison, reference is made to recent esti-mates by OPEC (2009), according to which invest-ments for the development of additional productioncapacity of 1 b/d are much lower. For the period of2010 to 2030, average investment costs of ca. 20,000US dollars/b/d in 2008 prices are listed, whereby thelowest are in the OPEC countries at 12,000 US dol-

lars/b/d and the highest required investments are inWestern Europe at ca. 26,000 US dollars/b/d.

The 5 US dollars/bbl calculated on the basis of theIEA figures stand for the linear write-offs on theinvestments; the interest that accrues in additionduring the life span of the projects is determined viathe annual annuities. For this, starting from the totalinvestment costs up to 2030 amounting to 5.036 tril-lion US dollars, capital costs for the producedamount of approximately 9.8 US dollars/bbl3 are cal-culated at an interest rate of 6 percent.4 Since theprice level for upstream investments from 2007 to2008 only increased by 1.5 percent, it is assumed thatthe price increase between 2007 and 2009 wasapproximately 3 percent, so that the capital costs in2009 should amount to 10.1 US dollars/bbl.Together with the average operating costs of 6.6 USdollars/bbl, total average production costs in 2009prices were 16.7 US dollars/bbl.

The following production costs – in each case in 2009prices – are calculated using this method for depositsopened up in the future in selected regions:

– Middle East: 4.1 US dollars/bbl,– Gulf of Mexico: 11.7 US dollars/bbl,– North Sea: 20.3 US dollars/bbl,– Canadian oil sands: 41.2 US dollars/bbl.

With the current projections of the IEA in the World

Energy Outlook 2009 there is a slight modification ofthe results. Because of the global financial market cri-sis, worldwide economic growth and with it also ener-gy demand will be lower than initially predicted. Theentire supply of oil in 2015, according to the currentIEA estimate, will only increase to 88.4 mb/d – 6 mb/dless than in the estimate of 2008. In 2030, the supplyof oil will be 105.2 mb/d, only 1.2 mb/d less than theearlier forecast. With this oil production costs willalso tend to be lower since the capital productivity willbe higher because of the higher share of oil extractedat lower expense. Hence, a production capacity of ca.105 mb/d is to be attained by 2030 and investments

CESifo Forum 4/2010 66

Special

2 Because of the recent recession, demand for oil will be lower thanestimated in the report at the end of 2008. Current development istaken into account in the IEA report of 2009.

3 These capital costs can only be given approximately because theunderlying annuity refers to a time period, whereas actual oil pro-duction has a different chronological structure. Oil production overtime generally follows an asymmetrical bell curve, with much of theactivity occurring at the beginning of extraction. By placing capitalcosts in relationship to the extracted amount, it is assumed that theoil production is constant each year in the period examined and thatno further investments are necessary in this period.4 The interest rate of 6 percent results from the long-term real capi-tal market interest rate of approximately 4 percent, as calculated forGermany (Bundesbank 2001), and a risk premium as is derived inthe Goldman Sachs (2008) study from the average of the total risk,comprised of the technical and the political risk.

Page 69: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201067

Special

are likely to be around 8 percent lower. For a produc-tion capacity of 1 mb/d, on average approximately44,000 US dollars are to be invested; this is on thebasis of a total volume of crude oil production of4.8 US dollars/bbl. The capital costs that accrue forthe amounts produced are 9.4 US dollars/bbl in 2007prices. This corresponds to ca. 9.7 US dollars/bbl in2009 and, together with average operating costs of6.6 US dollars/bbl, leads to total average productioncosts of 16.3 US dollars/bbl. It is implicitly assumedhere, however, that not least due to technologicalprogress in oil extraction no strong increase in extrac-tion costs will occur, as was observed in the years upto 2008.

In addition to the average oil production costs, con-sideration must also be given to the marginaldeposits (e.g. oil sands, deep sea deposits), which areof key importance for pricing in the oil market. Animpression of these marginal deposits can be gainedfrom the reports of the major US oil and gas pro-ducers to the Energy Information Agency (2009) ontheir own production costs. For the period 2006 to2008 they indicated that their average worldwideproduction costs (2008 prices) were approximately34 US dollars/bbl.

The results of the research and considerations of aver-age oil production costs as well as the shares of oilproduction costs in the average prices in recent yearsare given in Table 1. Future production costs refer inparticular to the period up to 2030. In light of the

averages listed in Table 1, it must not be overlookedthat oil production costs vary considerably dependingon the different deposits. Current production costs asa share of average oil prices for 2005 to 2009 liebetween 3 percent and 67 percent.

Natural gas production influenced by the oil marketand transport costs

The use of natural gas has expanding strongly world-wide in recent decades, and according to IEA esti-mates demand will continue to grow also in the com-ing decades. Natural gas is used predominantly forheating; its use as a fuel for transport is still of limit-ed importance worldwide. The main reasons for theincreasing use of natural gas are its favourable com-bustion qualities, its versatility and its better environ-mental compatibility in comparison with other com-bustibles. The extraction of natural gas is closely con-nected to mineral oil production, and often it is pro-duced simultaneously. For this reason extensiveanalogies to mineral oil exist with regard to produc-tion conditions and production costs. However, thereare far fewer studies available on the production costsfor natural gas.

For the estimation of the production costs for naturalgas from currently used deposits, the study byRemme, Blesl and Fahl (2007) can be used. Accordingto this study, the cost of natural gas extraction (in USdollar prices of 2000) as a weighted average of all

world areas is between 4 and5.5 US dollars/boe (barrel oilequivalent). The mean valuedetermined by this interval fornatural gas production costs (inprices of 2009) is nearly 6 US dol-lars/boe. In contrast, an IEAstudy of 2009 gives the range ofcosts for natural gas productionfrom conventional deposits; therange is between 2.7 and 32.5 USdollars/boe. Since it can beassumed that there is a tendencyto use the better gas sourcesintensively first, for 2009 produc-tion costs of between 5 and10 US dollars/boe are assumed;for the period up to 2030 a costrange of 8 to 20 US dollars/boeseems realistic. Here it must bepointed out, however, that the

Table 1

Production costs for crude oil and share of production costs

in oil prices (in 2009 prices)

Aguilera

et al.

Remme,

Blesl

and Fahl Jojahrt

Deutsche

Bank/Ifo IEA/Ifoa)

Oil production costs

of currently used

deposits in USD/bbl 11.0 11.0 11.8

Oil production costs

of future deposits in

USD/bbl 11.0 20.0

16.7

(16.3)

Percentage of

production costs in

the total oil priceb)

of

current deposits 16.0 16.0 17.2

Percentage of

production costs in

the total oil priceb)

of future deposits 16.0 29.1

24.3

(23.7)a)

IEA (2008) in brackets IEA (2009). – b)

Average prices from 2005 to

2009.

Source: Listed studies; Ifo Institute.

Page 70: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

transport costs for gas comprise up to 80 percent of

total costs of producing gas. For this reason it is plau-

sible to assume that a gas source that is cheaply acces-

sible but far from the markets will only be tapped

after an expensive field that is closer to the markets, if

prices are high.

For the determination of future production costs for

natural gas, recourse can also be made to the num-

bers of Remme, Blesl and Fahl (2007) and of

Aguilera et al. (2009), and again, as with crude oil,

to our own calculations made on the basis of the

IEA reports of 2008 and 2009. In the course of the

increasing depletion of the deposits classified as

reserves, the extraction of natural gas from known

resources takes on increasing importance. The costs

of the natural gas production from these deposits

are comparably low compared with the extraction

from more remote and difficult to access deposits.

The average production costs given by Remme, Blesl

and Fahl (2007) in US dollar prices of 2000 are

between 8.9 and 13 US dollars/boe. In 2009 prices,

average production costs for natural gas stood at

about 13.7 US dollars/boe.

In addition, according to Remme, Blesl and Fahl

(2007), for natural gas production even further in the

future, technologies and sources that are combined

with considerably higher costs will be likely. Among

these, ranked according to ascending costs, are the

increased exploitation of known deposits (EGR –

enhanced gas recovery), the extraction of gas from

coal, tight gas (gas in rock strata), aquifer gas or gas

hydrates. The costs of the natural gas extraction from

gas hydrates is at the upper limit and lies between

55 and 100 US dollars/boe (in 2000 prices); this corre-

sponds to a price range (in 2009 prices) of about 70 to

125 US dollars/boe.

The estimates of natural gas production costs by

Aguilera et al. (2009) are much lower; for future nat-

ural gas production and the growing reserves they cal-

culate average production costs of 4.8 US dollars/boe

(in 2006 prices) on the basis of amounts estimated by

the United States Geological Survey (2000). For addi-

tional deposits with higher extraction expense they

calculate average production costs of 12.6 US dol-

lars/boe. Thus, for the total amount of gas, produc-

tion costs amount to 6.6 US dollars/boe (in 2006

prices); on the basis of 2009 prices this means costs of

approximately 7.5 US dollars/boe. The gas quantities

accessible at these costs are, as for crude oil, consider-

ably higher than in other available estimates. Aguilera

et al. (2009) use a gas production volume of 3,375 bil-lion boe, which is three times the reserves of 1,115 bil-lion boe that ExxonMobil (2009) indicated.

As was done for crude oil, we estimate the unit costsof deposits to be accessed in future by means of the2008 IEA projections. Accordingly, worldwide natur-al gas production will increase from 2,959.3 in 2006 to3,512 billion m3 (2015) and 4,434 billion m3 in 2030.With the upstream investments in this period, com-pensation must be made not only for the growingdemand for gas but also for the natural productiondeclines of currently exploited deposits. We assume adecline in the production of present gas wells of 5 per-cent per annum on average; this rate will increase inthe coming years and will amount to approximately8 percent per annum in 2030. This means that on theone hand because of the production declines of pre-sent extraction sites, gas deposits with an annual out-put of 2,000 billion m3 to 2030 must be accessed andon the other hand that because of the rise in the ratesof decline of production capacity, a further increaseof approximately 1,225 billion m3 will be needed.With an increase of the supply of 1,475 billion m3, theextraction capacities must be expanded by 2030 by ca.4,800 billion m3 per annum, or converted into oil unitsby 30,258 mb/year. The IEA estimates investments of3,322 billion US dollars will be needed for the periodup to 2030 (2007 prices).

For an additional production capacity by 1 b/d,40,070 US dollars (2007) must be invested, on average.Assuming a typical service life of a gas deposit is25 years, investments are calculated at 4.4 US dol-lars/boe. There are, however, considerable differencesdepending on the deposits: In the OECD countriesinvestments are estimated to be around 67,500 US dol-lars/b/d (7.4 US dollars/boe), whereas in the non-OECD countries only ca. 30,000 US dollars/b/d(3.1 US dollars/boe) needs to be invested. Assumingtotal investment costs of 3,322 billion US dollars andan interest rate of 6 percent, capital costs with referenceto the extracted amount of 8.6 US dollars/boe result.In 2009 prices, this means capital costs of ca. 8.9 USdollars/boe. Together with the average operating costs5

of approximately 4.6 US dollars/bbl, total average pro-duction costs of 13.5 US dollars/bbl result for 2009.

Here too, using the 2009 IEA projections there is asmall modification of future production costs. Total

CESifo Forum 4/2010 68

Special

5 Here, the average operating costs of Aguilera et al. (2009) for 2009were used.

Page 71: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201069

Special

natural gas production, according to current IEA esti-mates, will only increase to 3,395 billion m3 in 2015 –117 billion m3 less than in the forecast for 2008. In2030 gas production at 4,313 billion m3 will be 121 bil-lion m3 below the earlier forecast. Accordingly, alsothe gas production costs will tend to be lower sincecapital productivity will be higher because of thehigher share of natural gas extractible at a smallerexpense. With this in mind, an annual gas productioncapacity of ca. 4,600 billion m3 must be attained,which in oil units corresponds to approximately29,000 mb/year, by 2030; investments should bearound 10 percent lower. For achieving a productioncapacity of 1 mb/d, ca. 37,700 US dollars must beinvested on average; in terms of the total extractedamount of natural gas this amounts to investmentcosts of 4.1 US dollars/boe. Capital costs calculatedon the basis of the total amount of gas producedamount to 8.1 US dollars/boe in 2007 prices. This cor-responds to ca. 9.3 US dollars/boe for 2009 andtogether with average operating costs of 4.6 US dol-lars/boe amounts to total production costs of 12.9 USdollars/boe. As is the case for oil, there is also a largerange of production costs worldwide for gas; becauseof the high share of transport costs and the prevailinglink to oil prices, the marginal sources have a weakerinfluence on gas price formation.

The results of the available cost estimates and ourconsiderations are summed up in Table 2. With refer-ence to the average costs listed in Table 2, it must bepointed out that because of the distribution of the

production costs, their share in prices currently fluc-tuates between 4 percent and 35 percent.

Large black (bituminous) coal reserves dampen costincreases

According to IEA information, coal’s share of world-wide primary energy consumption was 26.5 percent,making it the most important energy source aftermineral oil (34 percent). The importance of the coalas a source of energy has increased since 1990; itsshare in energy consumption grew in this period byone percentage point. Included in the different sortsof coal are brown coal and black coal. Whereasbrown coal is primarily used locally because of itslower energy content, for black coal there is an activeworldwide trade that has continuously expanded inrecent decades. Here, a distinction must be madebetween coking coal, which is mainly employed insteel production, and steam coal, which is used in theheating market. The by-far largest share in the world-wide coal market is for steam coal, with a share ofmore than three quarters. For this reason we only listthe production costs for steam coal, and only forthose countries that dominate the world coal market.This country group includes Indonesia, Colombia,Venezuela, South Africa, China, Australia, the UnitedStates and Russia. Here, it must be noted than inEurope and the United States, coal is used mainly inlarge plants for the production of electricity and heat;direct final consumption only plays a subordinate

role. For this reason, the highdegree of competition is oftengreater in the coal markets thanfor oil and gas.

In supply costs found in the liter-ature, the haulage costs to theconsumers or to the export portsare often included. This is be-cause haulage is very importantfor determining total productioncosts or the differences in pricefor coal. As a result the proximityof coal deposits to ports is a con-siderable site advantage for coal.Here, however, we only take intoconsideration the costs that areimmediately associated with pro-duction, that is the costs for capi-tal, labour, operations and pro-cessing. These are the costs free at

Table 2

Production costs for natural gas and share of production costs

in the gas price (in 2009 prices)

Aguilera

et al.

Remme,

Blesl and

Fahl

IEA

(2009)/Ifoa)

IEA/Ifob)

Natural gas production

costs for current

deposits in USD/boe 6.0 7.0

Natural gas production

costs for future

deposits in USD/boe 7.5 13.7 13.0

13.5

(12.9)

Percentage of

production costs in the

total gas pricec)

for

current deposits 14.1 16.5

Percentage of

production costs in the

total gas priceb)

for

future deposits 17.6 32.3 30.6

31.8

(30.4)a)

Conventional deposits. – b)

IEA (2008) in brackets IEA (2009). –c) Gas

prices from 2005 to 2009.

Source: Listed studies; Ifo Institute.

Page 72: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

the site of deposit, as they have been analysed bySchulz (1984a and 1984b) for different types of open-cast and below-surface mining operations.

The average production costs for steam coal from pre-sent deposits, in prices of 2006/2007, according toRitschel and Schiffer (2007) were between 5.5 and10.3 US dollars/boe, which in prices of 2009 is ca. 6 to11 US dollars/boe or, on average, ca. 8 US dollars/boe.The production costs calculated by the IEA (2009) areof a similar order of magnitude. Adjusted approxi-mately for the haulage costs contained in these num-bers, production costs of 7.2 US dollars/boe result;this number also includes the production costs ofexport-relevant mines in China and the United States,in contrast to Ritschel and Schiffer (2007). FollowingRemme, Blesl and Fahl (2007), production costs forsteam coal of 8.5 US dollars/boe for the current pro-duction can be derived; for future production theyindicate costs of about 13.5 US dollars/boe.

Currently approximately 5.6 Gt coal is produced perannum at an average cost of about 8 US dollars/boe.Production costs for additional black coal willincrease to a relatively small extent in the comingdecades (International Energy Agency 2010). Thecosts for the development and production of thefirst 100 Gt of the global coal reserves amount tobetween 5 and 25 US dollars/boe, according to cur-rent estimates. For the next 500 Gt, production costsare estimated to fall in a range of 8 to 40 US dol-lars/boe. During the production of the last 110 Gt

of the known reserves, a strong increase in costs islikely, the estimates ranging between 13 and 123 USdollars/boe. These coal reserves together wouldenable the present annual output to continue for aperiod of more than 120 years. Table 3 shows theproduction costs for steam coal from currently useddeposits and for the mined amounts in the period upto about 2030. In contrast to the average values inTable 3, the share of production costs of coal in theaverage price of steam coal is currently between28 percent and 61 percent.

That the conditions for an expansion of the world-wide coal supply are quite favourably can be seen inthe 2009 IEA report. An expansion of coal consump-tion of around 1.9 percent per annum between 2007and 2030 would require investments – in prices of2008 – of 661 billion US dollars. The demand for oiland gas in these years will increase less strongly, butwill require total investments of 5,919 billion and5,149 billion US dollars, respectively. Thus it wouldnot be surprising if the share of coal in the totalworldwide energy supply increased disproportionatelyon a long-term basis and if mineral oil and naturalgas is used even more strongly in areas, e.g. fuel fortransport, in which they have comparative advan-tages. Currently the use of coal is increasing stronglyin Asia, in particular in China. However, the compa-rably high carbon dioxide emissions connected withcoal argue against the increasing use of this source ofenergy. Since carbon dioxide is regarded as the prima-ry cause of the worldwide climate change, the increas-

ing used of coal can only be re-garded as responsible if it is donewith high combustion efficiencyor if the sequestration of emis-sions prevents the carbon dioxidefrom entering the biosphere.

Conclusion

In light of the great differences inextraction and the qualitative dif-ferences of energy resources fromthe individual deposits, the deter-mination of average productioncosts for the total production ofan energy source can only beunderstood as an approximationof actual costs. Table 4 containsthe average values of present andfuture production costs for crude

CESifo Forum 4/2010 70

Special

Table 3

Production costs for steam coal and share of production costs

in the coal price (in 2009 prices)

Ritschel

und Schiffer

Remme,

Blesl and

Fahl

IEA

(2009)/Ifoa)

IEAb)

Coal production costs

for current deposits in

USD/boe 7.9 8.5 7.2 8.2

Coal production costs

for future deposits in

USD/boe 11.5 10.0

Percentage of

production costs in

total coal pricec)

for

current deposits 44 47 40 46

Percentage of

production costs in

total coal priceb)

for

future deposits 64 56a)

IEA (2009); selected countries. –b)

IEA (2010) (expected), up to

100 Gt. – c)

Coal prices between 2005 and 2009.

Source: Listed studies; Ifo Institute.

Page 73: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201071

Special

oil, natural gas and steam coal, expressed in each casein barrels of oil or oil equivalent, as well as the respec-tive share of the average production costs in the aver-age energy source prices for 2005 to 2009.

For crude oil there are similarly clear circumstances,since world market prices exist for the different oilqualities. For 2009 average production costs crude oilof ca. 11.4 US dollars/bbl were determined. This cor-responds to a 17-percent share in the average oil priceof 2005 to 2009 of ca. 69 US dollars/bbl. The produc-tion costs for oil that will be produced in the period upto 2030 is likely to amount to 16 US dollars/bbl in2009 prices, on average.

With regard to natural gas, the situation is somewhatless clear especially because of the existence of sev-eral regional markets. The weighted average produc-tion costs of natural gas amounted to 7 US dol-lars/boe in 2009. With an average natural gas price ofca. 42.5 US dollars/boe, a ca. 16-percent share ofproduction costs can be calculated. For natural gasprovided in the period up to about 2030, productioncosts will probably amount to 11 to 12 US dol-lars/boe, in 2009 prices.

The production costs for steam coal refer only to theconditions in the most important exporting coun-tries. For 2009 and based on available studies, currentcosts of ca. 8 US dollars/boe can be calculated. Basedon the current average price of steam coal of ca.18 US dollars/boe, this amounts to a 45-percent shareof production costs, whereby the great differencesamong the providers must be kept in mind. Thefuture production costs for steam coal will increase ata comparably lower pace and will probably be of anorder of magnitude of 10 US dollars/boe in the peri-od up to 2030.

References

Aguilera, R.F., R.G. Eggert, G. LagosC.C. and J.E. Tilton (2009), “Depletionand the Future Availability of PetroleumResources”, The Energy Journal 30,141–174.

Deutsche Bank (2009), The Cost ofProducing Oil, London: Deutsche BankGlobal Markets Research.

Deutsche Bundesbank (2001), “Real-zinsen: Entwicklung und Determi-nanten”, Monatsbericht Juli, 33–50.

Dresdner Kleinwort (2006), Russian Oiland Gas: Key Trends and InvestmentOpportunities, November.

Energy Information Administration(2009), Performance Profiles of MajorEnergy Producers 2008,http://www.eia.doe.gov/emeu/perf-pro/0206(08).pdf.

ExxonMobil (2009), Oeldorado, http://www.exxonmobil.de/unternehmen/service/publikationen/downloads/files/oeldorado09_de.pdf.

Goldman Sachs (2008), Global: Energy, 190 Projects to Change theWorld, London.

International Energy Agency (2003), World Energy InvestmentOutlook 2003, Paris.

International Energy Agency (2005), Resources to Reserves, Oil & GasTechnologies for the Energy Markets of the Future, Paris.

International Energy Agency (2008), World Energy Outlook 2008,Paris.

International Energy Agency (2009), World Energy Outlook 2009,Paris.

International Energy Agency (2010), Resources to Reserves, forth-coming.

Jojahrt, C. (2008), The End of Easy Oil: Estimating AverageProduction Costs for Oil Fields around the World, Working Paper 72,Program on Energy and Sustainable Development, StanfordUniversity.

OPEC (2009), World Oil Outlook 2009, Vienna.

Remme, U., M. Blesl and U. Fahl (2007), Global Resources andEnergy Trade: An Overview for Coal, Natural Gas, Oil and Uranium,IER-Forschungsbericht 101, Universität Stuttgart, Institut fürEnergiewirtschaft und Rationelle Energieanwendung (IER),Stuttgart.

Ritschel, W. and H.W. Schiffer (2007), Weltmarkt für Steinkohle,Essen-Köln: RWE Power.

Schulz, W. (1984a), “Die langfristige Kostenentwicklung derSteinkohle am Weltmarkt (Teil I)”, Zeitschrift für EnergiewirtschaftMarch, 8–20.

Schulz, W. (1984b), “Die langfristige Kostenentwicklung derSteinkohle am Weltmarkt (Teil II)”, Zeitschrift für EnergiewirtschaftJune, 108–117.

United States Geological Survey (2000), World Petroleum Assess-ment, Washington DC.

Table 4

Production costs for energy sources and share of production costs

in the price of the energy source (in 2009 prices)

Oil Gas Steam coal

Average production costs for current

deposits in USD/boe 11.4 6.8 8.0

Average production costs for future

deposits in USD/boe 16.0 11.6 10.0

Percentage of production costs in

the total price of the energy source

for current deposits 17 16 45

Percentage of production costs in

the total price of the energy course

for future deposits 23 27 56

Source: Listed studies; Ifo Institute.

Page 74: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 72

Special

REPEC – AN INDEPENDENT

PLATFORM FOR MEASURING

OUTPUT IN ECONOMICS

CHRISTIAN SEILER AND

KLAUS WOHLRABE*

Introduction

Research assessments have become an importantpart of the academic world. Since they often formthe basis in appointment procedures and financingdecisions within the research world, the quality ofthe assessment depends significantly on the qualityof the underlying measurements (see Combes andLinnemer 2010). A well-known procedure inGerman-speaking countries for measuring researchoutput is the ranking of the daily business newspa-per Handelsblatt, which has gained a high degree ofattention in the area of economics (see Hofmeisterand Ursprung 2008). In addition to the rankingsfor authors there is also one for institutes. However,for the latter only economics departments at uni-versities are included and not research institutions(such as Ifo Institute or DIW Berlin). At the inter-national level there are the Times Higher WorldUniversity Ranking and the Shanghai Ranking.The focus of these studies is on a comparison ofuniversities.

In this article we present the RePEc network as anindependent platform for current research assess-ment, in particular in the area of the economics. Firstwe describe how RePEc functions, then we presenthow the rankings are calculated in the network, whichincludes both institutions (faculties, think-tanks, etc.)as well as authors. We also indicate how these rank-ings can be interpreted and some points that must bekept in mind. The advantages of this network are thegreat number of ranking criteria and that they arevery up-to-date.

The RePEc network

The RePEc network (Research Papers in Economics, )is a bibliographic service for economic research andits adjunct fields such as statistics. The goal of thisnetwork consists in constructing as complete a collec-tion as possible of all research results that have beenpublished in some form. Also, by using this informa-tion, various evaluations or rankings can be pro-duced. An important difference from many otherranking methods is that RePEc is based on the ‘wiki’principle and the relevant information is not compiledby an individual author or institution. This principleapplies both to authors as well as publishers, which tosome extent are dependent on each other. On the onehand, publishers must make available the meta-infor-mation of their publications (journal articles, books,book contributions, working papers) such as authornames, titles, editions, number of pages or citations.On the other hand, scholars must register themselvesat RePEc and classify their works. This enables a clearallocation to the authors. With the help of the infor-mation available in the network, rankings can be com-puted for authors and institutions. A potential disad-vantage, however, is that some information (e.g. par-ticular journals or citations) may not have been madeavailable to the network or, because of the concentra-tion on economic research, publications from otherdisciplines may not be included. For the researchcommunity there is thus a strong incentive to make asmuch information as possible available in order tofully exhaust the network effect.1

Ranking criteria

On basis of the bibliographic information available inthe network, RePEc releases monthly 34 differentrankings for registered authors as well as institutions.2

The basis is comprised of five main categories: thenumber of (registered) works as well as the numbersof pages of the journal articles, the number of cita-tions, the number of cited authors and access statistics

* Ifo Institute for Economic Research.

1 For further information on how the RePEc networks functions, seeZimmermann (2007).2 The RePEc network itself considers all its rankings to be experi-mental.

Page 75: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201073

Special

of the RePEc network. For some of these categories,

additional weightings with different quality features

are carried out (see Table 1 for an overview). In the

following the criteria are described in detail.

Number of works

For tallying the number of the works, all scholarly

publications, i.e. working papers, journal articles,

book contributions, books and software components,

are considered. Since articles can be published again

in different series (especially working papers) this can

lead to distortions in the evaluation. Therefore differ-

ent publications of the same article are counted only

as one individual work.

Number of pages

For the number of the published pages only the arti-

cles that have appeared in academic journals and as

book contributions are counted. The pages in work-

ing papers and books are not counted. Since books

and working papers as a rule are not subject to a

review process, the author has a strong influence on

the number of the pages, which in the case of articles

in academic journals is mostly determined externally.

With this criterion it must be noted however that the

number of characters per page can vary between jour-

nals and is not adjusted by RePEc.

Citations

For this criterion all citations registered in the net-

work are counted and assessed. In order to avoid an

artificial increase because of self-citations, these are

not taken into consideration. In addition to a simple

counting, the citations are also adjusted by the year of

citation in order to reflect the current scholarly dis-

course. This means that an article that was quoted in

recent years has more weight than an article that is

quoted just as frequently but further back in the past.

On basis of the citations Hirsch’s h-Index (2005) is

also calculated. This is defined as follows: a scholar

has an index of h if from his n articles h was quoted at

least h times. The remaining (n-h) articles do not have

more than h citations. This index reflects both the

quality and the breadth of research results. Scholars

with few but frequently cited works tend to have a

lower h-index. A stricter variant of the h-Index is the

Wu-index (see Wu 2008). This is calculated in a simi-

lar way as the h-Index, but one needs ten times as

many citations to reach a value of w.

Cited authors

A problem with the simple counting of citations isthat so-called ‘citation clubs’ can emerge in which afew authors quote themselves mutually. In order toavoid this, the number of different authors making thecitations is also counted. Here, a weighting is also car-ried out that depends on the rank of the author inRePEc. If a well-ranked author quotes a less well-ranked author, the latter profits more from this thanwhen he is quoted by an author whose ranking is notas high.

RePEc access assessment

In the RePEc network all abstract views and down-loads are registered. Automated accesses, e.g. byrobots, are registered by the system and filtered out.In addition a control is made for suspicious accesspatterns in order to avoid individual manipulations.All rankings based on these access assessmentsinclude only the last twelve months.

Quality weighting

In order to register the quality of scholarly works, inaddition to the citations, further quality features areconsidered: the published articles are weighted withthe impact factors of the publication series. These arecomputed by the network itself. In addition an adjust-ment is made for the number of authors.

Impact factors

The impact factors computed by RePEc differ fromthe semi-official impact factors of Thomson Scientificin that the latter uses only the number of articles fromthe past two years.3 The impact factor is calculated bydividing the number of the citations in year t of thearticles in the years t–1 and t–2 by the number of arti-cles that appeared in years t–1 and t–2. An impact fac-tor larger than 1 means that there are more citationsof the articles from the last two years than articlespublished in this period. There are also impact factorsthat include more than two years, but the above-men-tioned calculation method is the most widespread.The main difference between the RePEc method andthe semi-official impact factors is that a correspond-ing value is computed for every journal and workingpaper series. A comparison is only partially possible,

3 A good survey of the historical development and interpretation ofthe impact factor is given by Garfield (2006).

Page 76: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 74

Special

however, since the impact factors of RePEc are notchronologically limited and since citations from non-listed sources in RePEc or in other disciplines are notregistered. Another difference in the calculation of theimpact factors is that the self-citations of journals(which need not necessarily be by the same author)are not considered.

A possible disadvantage of the simple impact factorsis that all citations are weighted equally, i.e. citationsfrom top journals are treated the same way as cita-tions from journals of a lower standing. In order toadjust for this problem, the recursive impact factor iscalculated in addition. Here, however, there is an opti-misation problem since the weighting of the citationsin turn influences the underlying impact factor of thejournal. In its calculations RePEc uses algorithmsthat start with the simple impact factors and iterative-ly adjust the recursive impact factors. These recursiveimpact factors are to be interpreted in such a way thatthey measure the importance of the journals relativeto each other whereas the simple impact factors regis-ter the absolute importance.

Number of the authors

In addition to the qualitative weighting of an articlevia the impact factor of the series, the number ofauthors of a publication is also taken into consider-ation. The more authors an article has, the fewerpoints an individual author receives. Differences

between main and co-authors are not observed byRePEc; every author thus has an equal share in apublication.

Calculation of an overall ranking for authors

As evident in Table 1, not all combinations of thediscussed criteria and weighting are calculated. Thisis not always sensible (e.g. the weighting of down-loads according to impact factors) and in additionparticular criteria are to be assigned a greater weightin the calculation of the average ranking. This is par-ticularly the case for citations that form the basis for13 of the 33 rankings and are thus the main qualityfeature.

For every combination listed in Table 1, a value is cal-culated for every author, and based on this a rankingis made. These rankings form the basis for the overallranking. For every author the best and worst place-ment is removed and from the remaining placementsthe average ranking is formed with the help of har-monious averaging.4 Here neither the total number ofarticles nor the Wu index are taken into account. Theaverage rankings are sorted in ascending order andthus display the overall ranking.

Table 1

Academic rankings in RePEc

Wit

ho

ut

any

fu

rth

er

wei

gh

tin

g

Sim

ple

im

pac

t

fact

or

Rec

urs

ive

imp

act

fact

or

Nu

mb

er o

f au

tho

rs

Nu

mb

er o

f au

tho

rs

+ s

imp

le i

mp

act

fact

or

Nu

mb

er o

f au

tho

rs

+ r

ecu

rsiv

e im

pact

fact

or

Overalls XWorks

Distinct X X X X X X

Overalls X X X X X X Citations

Discounted by citation year X X X X X X

Overalls XCiting authors

Weighted by authors slim X

Journal pages X X X X X X

Abstract views X X Access via RePEc

Downloads X X

h-Index XIndices

Wu-Index* X

* Only for authors.

Source: www.repec.org.

4 Harmonious averaging is preferred over the arithmetic averaging bythose authors and institutions that are far in front in a few rankings,as is evident in Box 1.

Page 77: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201075

Special

Ranking of institutions

The idea of an institutional ranking is based on thefact that every institution can be seen as an individualauthor to which all the articles of affiliated personsare assigned. Every author who has registered worksin RePEc contributes an added value to the corre-sponding institution. Building on this, the total rank-ing is calculated similarly to that of the author rank-ing. This procedure is unproblematic as long as everyauthor can be assigned precisely to an institution. Butwhat happens if an author assigns himself to severalinstitutions?5 In such cases RePEc carries out a distri-bution to the individual institutions. The ‘main insti-

tution’ receives 50 percent, andthe remaining 50 percent is dis-tributed to all the other listedinstitutions, with a correctionbeing made for the number ofaffiliated persons. The main insti-tution is not indicated explicitlybut is determined by the regis-tered e-mail address or the indi-cated Website of the author.

A European ranking for authorsand institutions

Table 2 lists the 25 best institu-tions in Europe. A comparison ofthe worldwide ranking with theEuropean one shows, for exam-ple, that the Institute for FiscalStudies in London is in17th placein the worldwide ranking ofEuropean institutions but is in10th place in the Europe ranking.This inconsistency is a result ofthe formation of averages via therankings and is explained inBox 1 by means of an example.Table 2 also includes the numberof authors assigned to this insti-tution in RePEc. Here it is evi-dent that a high number does notnecessarily lead to a high place-ment, as can be seen in particularwith the Centre de Recerca enEconomia Internacional (CREI)in Barcelona. In general, itshould be noted for the institu-tional rankings that due to volun-

tary registration, the number of authors of a particu-lar institution in RePEc does not necessarily have tocorrespond with the actual number.

Table 3 shows the Europeans rankings for authors.The large discrepancy to the worldwide placementarises from the fact that all authors of the worldwideranking who are at least affiliated with one Europeaninstitution are taken into consideration in this rank-ing. This is problematic in particular if the relevant

Box 1

Illustration of the shifts in regional rankings

In addition to the ranking of all registered authors and institutions in the

RePEc network, regional rankings are also made, for example for

Germany and the European Union. Due to the affiliation of many authors

to institutions from different areas, it can be the case that an author’s name

appears in several regional rankings. Although institutions, unlike authors,

can be assigned unambiguously to a region, there can be inconsistencies

also in the institutional rankings similar to those in the Europe ranking.

The following simplified example briefly illustrates this problem:

Institutions A and B exist in a specific region. For these institutions,

rankings were made according to five different criteria (I-V) in the table

below. In the worldwide ranking, institution A is particularly well

positioned in Ranking I and II. Institution B does not stand out in any

criterion but is somewhat better than A in Rankings III–V. The average

ranking of Institution A, however, is less than that of Institution B because

of the clear advantage in I and II, both on the basis of the harmonic as well

as the arithmetic mean. If the rankings are transferred to the regional

assessments, the advantage of Institution A over B no longer exists. To be

sure, the underlying scores of A are still clearly better than those of B, but

since B is the second-best institution in this region according to criterion I

and II, the difference in the ranking is only that of one place. Since,

however, B is better than A in the other three rankings, a lower average

ranking for A results and with this a better placement in the regional

ranking. This is known as Simpson’s Paradox (see Simpson 1951) and

can only be resolved in this particular case if one were to calculate the

average scores instead of the average ranking. Since the scores between

the ranking criteria are not comparable, however (for the best placement

in I a score of 5 000 points is necessary, but for II only three points),

considerable distortions can result in such a calculation method.

Worldwide ranking

I II III IV V Harmonic

mean

Arithmetic

mean

A 9 11 202 234 198 23.1 130.8

B 175 182 135 152 178 162.3 164.4

Regional ranking

I II III IV V Harmonic

mean

Arithmetic

mean

A 1 1 2 2 2 1.4 1.6

B 2 2 1 1 1 1.3 1.4

5 A prominent example is the affiliation in academic networks, suchas the CESifo network or NBER. In most cases, this affiliation is thesecond institution next to the main institution.

Page 78: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 76

Special

authors are mainly active abroad but have assignedthemselves to a well-known network such as CESifoor CEPR. In the worldwide ranking for all authorsaffiliated with European institutions, Peter Phillips(Yale University, University of Auckland and

University of York) is in first place but in theEuropean ranking only in place 785. This poor place-ment is because less than 50 percent of his outputwent into the European ranking whereas 100 percentwas included for the worldwide ranking.

Table 2

Ranking of institutions in Europe: top 25

Wor

ldw

ide

Wor

ldw

ide

Eur

opea

nin

stitu

tion

s

Eur

ope

Inst

ituti

on

Cou

ntry

Num

ber

ofre

gist

ered

auth

ors

8 2 1 London School of Economics (LSE), London United Kingdom

216

7 1 2 Department of Economics, Oxford University, Oxford United Kingdom

142

19 3 3 Toulouse School of Economics (TSE), Toulouse France 128 35 5 4 Department of Economics, University College London

(UCL), London UnitedKingdom

69

36 6 5 Department of Economics, University of Warwick,Coventry

UnitedKingdom

66

40 8 6 European Central Bank, Frankfurt am Main Germany 122 33 4 7 CentER for Economic Research, Universiteit van

Tilburg, Tilburg Netherlands 139

38 7 8 Faculty of Economics, University of Cambridge,Cambridge

UnitedKingdom

68

43 9 9 Paris School of Economics, Paris France 171 69 17 10 Institute for Fiscal Studies (IFS), London United

Kingdom53

46 10 11 Organisation de Coopération et de DéveloppementÉconomiques (OCDE), Paris

France 144

56 12 12 Wirtschaftswissenschaftliche Fakultät, UniversitätZürich, Zürich

Switzerland 66

72 18 13 Institute for International Economic Studies (IIES),Stockholms Universitet, Stockholm

Sweden 20

67 15 14 Faculteit Economie en Bedrijfskunde, Universiteit van Amsterdam, Amsterdam

Netherlands 77

68 16 15 ECORE, Louvain-la-Neuve/Bruxelles Belgium 93 53 11 16 Faculteit der Economische Wetenschappen en

Bedrijfskunde, Vrije Universiteit, AmsterdamNetherlands 80

66 14 17 Solvay Brussels School of Economics and Management, Université Libre de Bruxelles, Bruxelles

Belgium 132

85 20 18 Innocenzo Gasparini Institute for Economic Research(IGIER), Università Commerciale Luigi Bocconi,Milano

Italy 39

87 21 19 Centre for Economic Policy Research (CEPR), London United Kingdom

258

91 23 20 Centre de Recerca en Economia Internacional (CREI),Barcelona

Spain 14

76 19 21 School of Business and Economics, MaastrichtUniversity, Maastricht

Netherlands 105

65 13 22 ifo Institut für Wirtschaftsforschung e.V., München Germany 123 89 22 23 DIW Berlin (Deutsches Institut für

Wirtschaftsforschung), BerlinGermany 119

99 25 24 Institut National de la Statistique et des ÉtudesÉconomiques (INSEE), Government of France, Paris

France 56

95 24 25 School of Economics, University of Nottingham,Nottingham

UnitedKingdom

65

Source: www.repec.org (Status: October 2010 ranking).

Page 79: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201077

Special

Closing remarks

This article has discussed how the RePEc network

operates. In addition to the aspect of the registration

and dissemination of economic research, the rankings

it makes play an important role in the evaluation of

authors, institutions and journals. The main advantage

is in the dissemination of networks, i.e. a major por-

tion of research output in economics (including work-

ing papers) is registered. This is, however, only guaran-

teed if bibliographic information is regularly main-

tained and the authors keep their profiles updated. In

order to fully exhaust the network effects, it is impor-

tant to list authors and journals that are still missing in

RePEc. The independent preparation of 34 individual

rankings in addition provides a transparent assess-

ment of the research output on the basis of different

criteria both for authors and for institutions.

References

Combes, P.-P. and L. Linnemer (2010), Inferring Missing Citations: AQuantitative Multi-Criteria Ranking of All Journals in Economics,www.vcharite.univ-mrs.fr/pp/combes/Journal_Ranking.pdf.

Garfield, E. (2006), “The History and Meaning of the Journal ImpactFactor”, Journal of the American Medical Association 295, 90–93.

Hirsch, J.E. (2005), “An Index to Quantify an Individual’s ScientificResearch Output”, Proceedings of the National Academy ofSciences 102, 16569–16572.

Hofmeister, R. and H.W. Ursprung (2008), “Das HandelsblattÖkonomen-Ranking 2007: Eine kritische Beurteilung”, Perspektivender Wirtschaftspolitik 9, 254–266.

Simpson, E.H. (1951), “The Interpretation of Interaction inContingency Tables”, Journal of the Royal Statistical Society,Series B, 13, 238–241.

Wu, Q. (2008), The w-Index: A Significant Improvement of the h-Index, http://arxiv.org/abs/0805.4650v1.

Zimmermann, C. (2007), Academic Rankings with RePEc,Department of Economics Working Paper 2007-36R, University ofConnecticut.

Table 3

Ranking of economists in Europe: top 25

Worldwide Worldwide European authors Europe Author

9 2 1 Jean Tirole

30 5 2 Lars E.O. Svensson

35 8 3 Jordi Gali

38 9 4 Richard Blundell

79 16 5 Timothy J. Besley

80 17 6 Stephen John Nickell

87 20 7 Guido Tabellini

65 13 8 Florencio Lopez-de-Silanes

19 4 9 Nicholas Cox

103 26 10 Ernst Fehr

67 14 11 Bruno S. Frey

32 6 12 Peter Nijkamp

126 32 13 Torsten Persson

139 38 14 Christopher A Pissarides

140 39 15 Andrew J. Oswald

50 12 16 M. Hashem Pesaran

152 41 17 Soren Johansen

132 35 18 David F. Hendry

149 40 19 Anthony J. Venables

182 47 20 John Moore

153 42 21 Gilles Saint-Paul

188 48 22 Stephen Roy Bond

180 46 23 Assar Lindbeck

121 30 24 Hans-Werner Sinn

203 56 25 Athanasious Orphanides

Source: www.repec.org (Status: October 2010 ranking).

Page 80: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 78

Trends

FINANCIAL CONDITIONS

IN THE EURO AREA

The annual growth rate of M3 stood at 1.0% in October 2010, compared to1.1% in September 2010. The three-month average of the annual growthrate of M3 over the period from August to October 2010 rose to 1.1%, from0.8% in the period from July to September 2010.

Between April and November 2009 the monetary conditions index re-mained rather stable after its rapid growth that had started in mid-2008.The index started to grow again since December 2009, signalling greatermonetary easing and reached its peak in June 2010. In particular, this hasbeen the result of decreasing real short-term interest rates. However, theindex started to decline again since June 2010.

In the three-month period from September to November 2010 short-terminterest rates increased. The three-month EURIBOR rate grew from anaverage 0.88% in September to 1.04% in November. The ten-year bondyields also increased from 3.50% in September to 3.73% in November. Inthe same period of time the yield spread increased from 2.62% (September)to 2.69% (November).

The German stock index DAX grew in November 2010, averaging6,688 points compared to 6,229 points in September. The EuroSTOXX also increased from 2,766 in September to 2,810 in November.The Dow Jones International grew as well, averaging 11,198 points inNovember compared to 10,598 points in September.

Page 81: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/201079

Trends

According to the first Eurostat estimates, GDP increased by 0.4% in theeuro area (EU16) and by 0.5% in the EU27 during the third quarter of2010, compared to the previous quarter. In the second quarter of 2010 thegrowth rates were 1.0% in both zones. Compared to the third quarter of2009, i.e. year over year, seasonally adjusted GDP increased by 1.9% in theeuro area and by 2.2% in the EU27.

In November 2010, the Economic Sentiment Indicator (ESI) continued toimprove in both the EU27 and the euro area (EU16). The indicatorincreased strongly, by 1.3 of a point in the EU27 and, more significantly,by 1.5 of a point in the euro area, to 105.2 and 105.3 respectively. In boththe EU27 and the euro area the ESI stands above its long-term average.

* The industrial confidence indicator is an average of responses (balances) to thequestions on production expectations, order-books and stocks (the latter with invert-ed sign).** New consumer confidence indicators, calculated as an arithmetic average of thefollowing questions: financial and general economic situation (over the next12 months), unemployment expectations (over the next 12 months) and savings (overthe next 12 months). Seasonally adjusted data.

In November 2010, the industrial confidence indicator improved by0.7 points in the EU27 and by 0.9 points in the euro area (EU16). On theother hand, the consumer confidence indicator increased by 0.5 points in theEU27 and, more strongly, by 1.5 points in the euro area.

Managers’ assessment of order books improved from – 16.3 in September to– 13.5 in November 2010. In August the indicator had reached – 18.4.Capacity utilisation increased to 77.9 in the fourth quarter of 2010, from77.3 in the previous quarter.

EU SURVEY RESULTS

Page 82: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year

CESifo Forum 4/2010 80

Trends

The exchange rate of the euro against the US dollar averaged 1.37 $/€ inNovember 2010, an increase from 1.31 $/€ in September. (In August therate had amounted to 1.29 $/€.)

The Ifo indicator of the economic climate in the euro area (EU16) rose onceagain marginally in the fourth quarter of 2010, and is now only slightlybelow its long-term average. The assessments of the current economic situ-ation were considerably more favourable than in the third quarter of 2010.The expectations for the next six months, however, were once again weakeralthough they remain positive on the whole. The survey results indicate thatthe economic recovery in the euro area will continue in the coming sixmonths, albeit at a slower pace than before.

Euro area (EU16) unemployment (seasonally adjusted) amounted to 10.1%in October 2010, compared to 10.0% in September. It was 9.9% in October2009. EU27 unemployment stood at 9.6% in October 2010, also unchangedcompared to September. The rate was 9.4% in October 2009. In October2010 the lowest rate was registered in the Netherlands (4.4%) and Austria(4.8%), while the unemployment rate was highest in Spain (20.7%) andLatvia (19.4% in the second quarter of 2010).

Euro area annual inflation (HICP) was 1.9% in October 2010, comparedto 1.8% in September. A year earlier the rate had amounted to – 0.1%. TheEU27 annual inflation rate reached 2.3% in October 2010, up from 2.2%in September. A year earlier the rate had been 0.5%. An EU-wide HICPcomparison shows that in October 2010 the lowest annual rates wereobserved in Ireland (– 0.8%), Latvia (0.9%) and Slovakia (1.0%), and thehighest rates in Romania (7.9%), Greece (5.2%) and Estonia (4.5%). Year-on-year EU16 core inflation (excluding energy and unprocessed foods)rose to 1.1% in October 2010 from 1.0% in August.

EURO AREA INDICATORS

Page 83: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year
Page 84: A joint initiative of Ludwig-Maximilians-Universität …timeline that ended in 2009. Tariffs and non-tariff barriers were eliminated on 65 percent of North American goods by the 5-year