SYNOPSIS: NAFTA's effects have been basically nil outside of political realms.

From 'The New Democrat' More than two years ago, the United States, Canada, and Mexico entered into the North American Free Trade Agreement. Debate over the pact was marked both by extravagant promises about its benefits and by blood-curdling warnings about its costs. Now that some time has passed, it's fair to ask, "How is NAFTA doing?"

To many, the answer is obvious: Haven't events in Mexico--economic crisis, political unrest, the revelation of scandals--given the lie to NAFTA's supporters? But that visceral reaction misses the point. Whether we like what we see in Mexico or not, the place isn't going away. There are 100 million people right next door, with whom we must live one way or another. The right question to ask about NAFTA is not whether conditions in Mexico and our relations with it are all that we wish they were, but rather whether they are better under NAFTA than they would have been without it. And despite recent troubles, the clear answer is yes. Indeed, the real value of the new U.S.-Mexican relationship is best seen in adversity: Mexico is coping with its latest crises better than almost anyone would have imagined in the pre-NAFTA era.

NAFTA's defenders are saddled with a big public relations problem: The agreement was sold under false pretenses. Over the protests of most economists, the Clinton Administration chose to promote NAFTA as a job-creation program. Based on little more than guesswork, a few economists argued that NAFTA would boost our trade surplus with Mexico, and thus produce a net gain in jobs. With utterly spurious precision, the Administration settled on the figure of 200,000 jobs created--and this became the core of the pro-NAFTA sales pitch.

The overall number of U.S. jobs, however, was never going to be noticeably affected by swings in our trade balance with Mexico. Our economy employs more than 120 million workers; it has added more than 8 million jobs since 1992. Job growth has slowed since 1994, but not because those 200,000 export-related jobs failed to materialize (the real culprit is the Federal Reserve's interest rate policies).

If job creation isn't the point of NAFTA, what is? Another possible justification is the classic economic argument that free trade will raise U.S. productivity and hence living standards. Few economists, however, thought the pact would yield large gains of this type. Mexico's economy is simply too small to provide America with the opportunity for major gains from trade. Typical estimates of the long-term benefits to the U.S. economy from NAFTA are for an increase in real income on the order of 0.1 percent to 0.2 percent.

So, where's the payoff from NAFTA for America? In foreign policy, not economics: NAFTA reinforces the process of economic and political reform in Mexico.

Mexican Reform: Myths and Realities

As vast sums of money flowed into Mexico in the early 1990s, it became chic to talk about the "Mexican miracle." The country was lauded for its economic reforms; President Carlos Salinas became a business celebrity. But when enduring weaknesses in Mexico's political and economic systems manifested themselves in 1994--the peasant uprising in Chiapas, the assassination of presidential candidate Luis Donaldo Colosio--the same investors who had been euphoric about Mexico a few months earlier panicked. They were shocked--shocked!--to discover that Mexico, after all, isn't a combination of Switzerland and Singapore. And they began pulling their money out as fast as they had poured it in.

All of this could have been avoided if people had taken a realistic view of events in Mexico. By the early 1980s, the political and economic models that had ruled the nation for 50 years had reached a dead end. Mexico had tried to build political stability on the basis of one-party rule and economic development on the basis of a protected market and a powerful state sector. Eventually, it became clear that other developing countries' market-oriented, export-driven economies were leaving Mexico in the dust. It also became clear that serious economic reform could take place only along with a serious democratization.

The international debt crisis of the 1980s, which wreaked havoc with the Mexican economy, had the paradoxical effect of opening up the possibility for real change. During the crisis, the Mexican ruling party turned to technocrats--most of them U.S.-educated, and many of them possessing a strong sense of the virtues of U.S. institutions--to solve the country's predicament. Salinas turned out to have been less than a whole-hearted reformer. Still, he brought into power a group that was astonishingly honest, pro-market, and pro-democracy by any previous Mexican standards.

And the technocrats produced real reform. Mexico's markets are far more open to U.S. exports than they have been since the early years of this century; many of the most wasteful and inefficient public enterprises have been privatized; a new economic base has emerged in the north, far from the inefficiency and corruption of Mexico City. Much has changed on the political front, too: Mexico's elections are freer and fairer than ever before.

Mexico may not be Canada, but it is a far better neighbor now than it has been in living memory. Even more important, a reformist Mexico led by pro-American technocrats is far preferable to the radical, anti-American nation we will surely face if the reformers fail. Clearly, it is in our interest to help the Mexican reformers succeed.

This is the context for judging the decision to go ahead with NAFTA. The agreement was a Mexican idea--proposed by Salinas to lock in the reforms he had begun and to build confidence about Mexico's future as a liberalized economy. How could we have refused? Rejecting Salinas's proposal would have been a devastating slap in the face for the reformers, who would have been taunted with the way that America rewards its friends.

Sensible NAFTA supporters had no illusions about Mexico. It is still a country with corrupt political bosses, tycoons whose fortunes are built on bribery, backward rural areas whose populations are virtually disenfranchised, and urban pockets of luxury ringed by slums. But it is less like that than before. Mexico's hope to become a better place and our hope to have a better neighbor depend on continued reform.

Crisis and Rescue

By early 1993, economists had begun to warn about the risks of a Mexican financial crisis. They were concerned about the dissonance between the wild optimism of investors, who were pouring money into Mexico at the rate of about $30 billion a year, and the still disappointing performance of the real Mexican economy, which was not yet delivering substantial improvements in living standards for ordinary families.

The failure of Mexican reforms to generate immediate rapid growth should not have been a big surprise. Economic reform is usually a painful process; the dislocations that are caused when old industries are no longer protected or subsidized tend to be more visible than the growth of new industries for at least several years. Chile did not begin to show a dramatic payoff to its market reforms until the mid-1980s, a decade after those reforms began; Eastern European nations like Poland and the Czech Republic, which escaped Soviet rule in 1989, are only now beginning to achieve solid growth. And the massive inflow of capital to Mexico between 1990 and 1994 in some ways actually delayed the economy's transformation. By leading to a severely overvalued peso, it slowed the emergence of new manufacturing exports--the engine of long-term economic growth.

Investors were too caught up in the investment boom to realize it was premature. Finally, their confidence began to falter in 1994 as Mexican politics and policies began to waver. The uprising in Chiapas posed no real threat to the government, but it was a reminder both of the vast, persistent inequities in Mexican society and of the limited progress made toward democracy. The assassination of Colosio, which remains something of a mystery, deprived the country of a much-needed leader and raised further doubts about stability. Also, during the run-up to the 1994 election, the Mexican government backslid on its record of responsible monetary and fiscal policies, printing and spending more money than it should have in an effort to buy votes.

The result was the crisis of December, in which a loss of confidence by investors forced a devaluation of the peso. By itself, the speculation against the peso need not have been a catastrophe. After all, currency crises are a common occurrence in the world of international finance. In fact, since 1990 major currency crises have forced devaluations not only in Mexico but in Britain, Finland, Ireland, Italy, Spain, and Sweden. The difficulties were increased when Mexico's devaluation was bungled, owing to missteps by a few officials (who were soon dismissed). They delayed the inevitable too long, carried out the devaluation half-heartedly, and managed in general to convey a sense of both arrogance and incompetence that further decreased confidence. Nonetheless, this too is fairly standard when there is a currency crisis, and Mexico's handling of the situation was no worse than that in many other countries.

The reason that Mexico's crisis soon ballooned to really dangerous proportions was that financial markets, which had been excessively euphoric about Mexico in the previous few years, overreacted in the opposite direction when the country hit a rough patch. This financial panic threatened to become a self-fulfilling crisis of confidence in the whole process of reform.

In simplified outline, this is what happened: As investors grew worried about Mexico during the second half of 1994, the country began running out of foreign exchange reserves. To maintain the peso's value, the government would have had to raise interest rates sharply, which would have pushed the faltering economy into a recession. Instead, the government let the peso fall. Investors, in turn, became so disillusioned that they withdrew all their money from Mexico, sending the peso into a freefall. To keep the currency from collapsing, which would have triggered explosive inflation, the Mexican government raised interest rates after all indeed, to very high levels.

At this point, a vicious circle developed. For more than a year, interest rates in Mexico have been very high--so high that investing there will be highly profitable unless there is a further huge fall in the peso. And there is no good economic reason to expect such a fall: Mexican exports are booming, the trade deficit has been eliminated, by any normal calculation the peso is undervalued. Investors, however, fear that the rule of the economic reformers in Mexico is in danger; that to put money into Mexico is to risk losing it when there is a nationalist backlash against the whole pro-market, pro-U.S. policy direction of the last decade. To induce them to keep their funds in Mexico despite such fears, the government has been forced to keep interest rates very high.

Why might there be a backlash? The biggest reason is the severe slump in the Mexican economy--a slump due mainly to high interest rates.

In short, investors are in effect saying, "I won't invest in Mexico unless I am offered a very high rate of return. I need that high rate of return to compensate me for the risks of a nationalist reaction, which may be sparked by the need to provide investors like me with such a high rate of return." It is a classic case of self-fulfilling pessimism.

What can be done? The best answer is to ride out the storm. In time, the vicious circle should become a virtuous circle. After all, at current interest rates, investing in Mexico is an extremely profitable proposition unless you fear either hyperinflation or expropriation. If time passes and these risks don't materialize, people will become more willing to invest in Mexico. This will allow interest rates to fall, which will produce an economic recovery, which will further reduce the perceived risks, and so on.

The great risk in 1995 was that the Mexican reformers would not be able to ride out the storm--that the financial markets' self-fulfilling pessimism would destroy their credibility before there was any chance to turn things around. It is in this light that one must understand the $50 billion rescue package put together by the United States and other advanced countries. We extended Mexico a large line of credit to buy the reformers some time.

The rescue attempt must be evaluated in terms of the alternatives. Should we have simply stood aside? This almost certainly would have doomed the Mexican reformers. If this had happened, it's a safe bet that Republican Sen. Al D'Amato, who held hearings to grill Administration officials over the decision to grant President Ernesto Zedillo's government a line of credit, would have instead held hearings demanding to know, "Who lost Mexico?"

Like the U.S. decision to go ahead with NAFTA in the first place, the rescue package was less an economic measure than a foreign policy move. Anyone who thinks it put too much taxpayer money at risk should try to make a realistic estimate of the cost of policing a 2,000-mile border with a hostile and angry neighbor. Even though the rescue plan was not guaranteed to succeed, it is hard to see how the United States could responsibly have done anything else.

The Current Prospects

The most important development in Mexico this past year is what has not happened. The ruling party has not abandoned its course of economic and political reform. Nor is there a serious challenge to the legitimacy of the government, either from armed peasants or populist politicians. The ruling party may well lose the next presidential election, but if it does, the likely victors will not be anti-market populists but pro-marketeers who will continue the process of reform. Mexico's political center is holding.

Meanwhile, it is beginning to look as if the virtuous circle Mexico's rescuers hoped for is materializing. Mexico's interest rates have dropped and its stocks have risen in recent months, and local economists are starting to talk about a fairly brisk short-term economic recovery. Furthermore, with private capital returning, Mexico has started to pay back its emergency loans. It now looks very likely that whatever else may happen, the American taxpayer will get his or her money back.

The recovery is still more a prospect than a reality, and things could still go very wrong. In particular, if U.S. politics turn protectionist and isolationist, it is hard to see how either Mexican recovery or Mexican reform can survive. But for now, at least, things are looking up.

Will this short-term stabilization prove to be the beginning of a new period of sustained growth? Has Mexico really turned a corner, or is this just the latest in a series of crises? Nobody knows. But this is the wrong question to ask. One cannot repeat it too often: Mexico cannot be wished away. We cannot wall it off behind an electrified fence and then forget about it. The important question for the United States is not whether we like everything we see south of the border. It is whether our interests would have been better served by the radicalized Mexico we would have faced if we had rejected NAFTA or denied it a financial lifeline last year--or by the struggling, troubled, but still reforming nation we actually have to deal with. By that test, NAFTA and the rescue that followed have been wise, successful policies.

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