Turning Twenty

Yesterday, as the North American Free Trade Act (NAFTA) entered its twenty-first year of implementation, its impact on the three partner countries (Canada, the U.S., and Mexico) is especially salient, given the current free trade talks underway or pending at the negotiating tables of the Trans-Pacific Partnership (involving 12 countries, including NAFTA's three, aimed at opening trade between Asia and the Americas), the U.S.-EU, and the World Trade Organization.

Overall, under NAFTA, trade flows have doubled between Canada and the U.S., and nearly tripled between Mexico and the U.S. The Act can hardly be said to have been responsible for all of this extraordinary expansion, but most analyses indicate that the elimination of tariff and non-tariff barriers to North American trade clearly played a principal role.  Mexico, in 1994 a poor, insular, and chronically under-performing economy experiencing frequent currency and balance of payment crises, has been particularly affected: twenty years on, it is considered a robust emerging economy, with exports of about $1 billion a day (10 times what they were in 1994), and with a GDP that places it now as the 13th-largest economy in the world (though on a per capita basis it still ranks much lower, at 57 among 187 countries). Had Mexico not waited the last 20 years to introduce internal growth-enhancing reforms to the economy, NAFTA's impact would have been even greater. Nonetheless, whole industries in Mexico have been transformed. Agriculture is one, with an incessant move to larger, more productive farms whose products show up increasingly in American and Canadian grocery stores. As well, auto manufacturing and assembly has grown hugely, on track to produce 4 million vehicles a year within 5 years; Mexico is now the fourth-largest exporter of vehicles in the world. Nearly every automaker is now making cars in Mexico. With the certainty of NAFTA's tariff-free framework, new auto plant investment continues, with Germany's Audi the latest to announce a  $1.5 billion plant construction in Mexico's heartland, the state of Puebla, where it will assemble its luxury Q5 SUV. Auto-industry jobs have jumped 50 per cent since 1994, and although they are very low-paid relative to auto workers in America and Canada, they are highly sought after by Mexicans, and have contributed to a rapidly emerging middle class.

An oft-argued NAFTA negative is that growth in Mexican manufacturing and jobs has been at the expense of those in America and Canada. Two counterpoints apply here: one, trade specialists, like Stephen Blank, an expert on North American integration, notes that advanced nations throughout the world have been losing manufacturing jobs - Free-Trade Agreements or not - in part because with modern processes and robotics, fewer people are needed to produce more goods, cars or otherwise. This is the productivity argument; the loss of jobs in places like Michigan and Ontario has come from technology, not from trade. Secondly, and just as interestingly, Blank notes it may not even be relevant to talk about trade between countries anymore. The NAFTA three don't trade with each other, he says, they make things together. Thus, Canadian exports to America contain 25 per cent inputs from the U.S.; Mexico has 40 per cent U.S. inputs. And, continuing the logic, why did Canada alone just sign a free-trade deal with Europe (and the U.S. will soon follow, then Mexico), instead of a more strategic approach from these three, highly-integrated economies negotiating as one unit?

David Ricardo, the 18th-century political economist who postulated the benefits of free trade and comparative advantage, would have loved this discussion. And he would have been little surprised by NAFTA's contribution to Mexico's rise, and to America's and Canada's post-industrial transition.

Preventing Another Benghazi, and Rwanda

This Christmas week, the Obama administration, no doubt remembering the tragedy in Benghazi in the fall of 2012, has directed the Pentagon to aggressively re-position Marines. And, in a related move, the U.N. Security Council has convened, leading to the urgent passing yesterday of a resolution.

Stationed in Spain, US forces and aircraft were moved on Monday into the Horn of Africa, specifically to Djibouti, where America maintains its only permanent African base. And yesterday, fifty of those marines were moved again, from Djibouti into Entebbe, Uganda, to be closer - within 500 miles - to Juba, the capital of the world's newest country, South Sudan. Also yesterday, the U.N. Security Council approved a direct request from Secretary-General Ban Ki-Moon to send 5,500 more peacekeepers to South Sudan. This will nearly double the number of U.N. troops there, boosting efforts to protect tens of thousands of Sudanese civilians displaced from their homes, seeking refuge at U.N. bases in and around Juba and Bor, a state capital to the north.

All this comes in the midst of a report yesterday from the U.N. High Commissioner for Refugees of the discovery of at least two mass graves in the town of Bentiu, in oil-rich Unity state, and of reports of attacks and killings throughout the country based on ethnicity. Intense diplomatic efforts are underway, through the US Embassy in Juba, via Secretary Kerry's special envoy for South Sudan, Donald Booth, and from visiting Ethiopian and Kenyan leaders, to contain this growing ethnic violence that, it is feared, could morph into the next Rwanda or Somalia. South Sudan President Salva Kiir, an ethnic Dinka, maintains that an attempted military coup 10 days ago by his sacked Vice President, Riek Machar, an ethnic Nuer, set off the violence. But unrest in recent weeks had already escalated to the point that America's State Department ordered the evacuation of all Americans from the country; in one such operation this past weekend to remove Americans in Bor, three CV-22 Osprey military aircraft were hit by gunfire, four U.S. crew members were injured, and the three aircraft were forced to abort the mission and return to their Entebbe base.

Re-positioning its Marines, evacuating its citizens, and dispatching its envoys, are decisions that reflect America's experience last year in Benghazi, Libya when no U.S. forces were close enough to respond quickly to the attack that killed U.S. Ambassador Stevens and three other Americans. But America has broader interests in the region as well: for years it has strongly supported the development of a functional, democratic South Sudan to act as a hedge against the regime in Khartoum, which is considered a sponsor of terrorism, and against Sudan President al-Bashir personally, who has been indicted on charges of war crimes and genocide. And even more broadly, America knows that further instability in South-Sahel Africa will only serve to strengthen the influence of Islamist extremists, already exploiting political vacuums in northern Nigeria and Mali in the west to Somalia and Kenya in the east.

Sudan suffered a 22-year civil war that left more than a million people dead before the South became independent in 2011. The hope now is that South Sudan, with its warring, and shifting, ethnic factions, won't replicate that experience.

The Taper Tale

The impact from yesterday's announcement following the 2-day Federal Open Market Committee (FOMC) meeting was different this time.

Past announcements from Ben Bernanke, Chairman of the Federal Reserve Board, in which there was even a hint of an impending draw-back of monetary stimulus (so-called "tapering" of the Fed's bond-buying program) were typically followed by a significant sell-off in the financial markets. Thus, for example, the Dow Jones Industrial Average dropped by as much as 3-5% in the few days after each of the July, September and October FOMC meetings. Each time, markets began to get a sense that tapering was just around the corner, and thus responded negatively, a reaction dubbed the "taper tantrum".

But yesterday, past tantrums turned into a big rally. Once Chairman Bernanke began his press conference at 1:50PM (his last as Chairman as he is succeeded by Janet Yellen next year), the Dow began climbing, closing the day some 292 points, or 1.8%, higher. Even long-bond yields dropped initially, though their upward trend has resumed today as bonds have sold off somewhat. Instead of just hints, the Chairman announced that tapering will in fact begin, next month, in a modest way, with the Fed reducing its monthly purchases of bond and mortgage-backed securities, by $5 billion for each, lowering total purchases from $85 to $75 billion per month. Moreover, tapering would likely continue after future meetings in "measured steps", but such would be data dependent, with no preset plan. Tapering is not tightening, the policy statement asserted, and short-term interest rates will not be raised until 2015 at the earliest, when the unemployment rate is expected to fall below the Fed's threshold of 6.5%. Indeed, in a new line in the statement, Mr. Bernanke noted that the Fed will likely keep the fed funds rate near zero "well past" the time when the jobless rate reached 6.5%. It appears it was precisely this very dovish forward guidance that the markets found so bullish.

The wild card of sorts in determining future Fed policy is inflation. Yesterday's policy statement included this new emphasis: "The Fed recognizes that inflation persistently below its 2 per cent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that it will move back toward its objective over the medium term". In other words, the Fed is clearly concerned about very low and falling inflation - that is, disinflation - as the threat of such a trend is that it can morph into outright deflation. It is extraordinary that, despite the Fed's program of quantitative easing, injecting massive amounts of money into the economy, inflation has continued to fall. Economists explain this by noting that most of the injected stimulus cash has remained in the form of banks' excess reserves, because demand for credit is still tepid, and because its supply is deliberately constrained by cautious bank lending practices. In their jargon, money velocity is very low.

Stay tuned over the next several months, as it may well be that inflation trends, much more than changes in unemployment, become the principal criteria for the timing and amount of further tapering. It's certain that if inflation falls more, tapering will stop, and may be reversed. As the Fed has said many times, it's all data dependent.

Two Pending Deals

The upcoming holidays seem to have focused politicians' minds. In Washington last night, a bi-partisan Congressional budget committee convened after an October government shutdown has reached a two-year budget proposal, expected to come to a vote in both the House and the Senate before the Christmas recess. And in Brussels this morning, EU finance ministers got very close to finishing a blueprint for a Europe-wide mechanism for rescuing troubled banks directly, rather than through bail-outs to individual governments , their objective being to "minimize taxpayers' exposure to losses".

The budget proposal in Washington, authored by Republican Congressman Paul Ryan and Democratic Senator Patty Murray (the respective chairs of the House and Senate budget committees) finances the government for two years and carves out some $23 billion of debt. (As perspective, recall that total federal debt is $17 trillion.) It will thereby avoid another government shutdown on January 15, the deadline for current funding, and according to Mr. Ryan, "cuts spending in a smarter way", a reference to the further, automatic and blunt, "sequester" expenditure cuts ( totaling $63 billion and applied mostly to the Pentagon budget) that without this deal would have occurred in the new year. Taxes will not be raised, though there are some revenue measures in the proposal, including a new federal airport security fee. The announcement of the proposed deal is seen as something of a breakthrough, given years of partisan deadlock. But consider, it is nothing more than a budget document - something Congress is normally expected to devise and implement - and, moreover, a budget that doesn't even try to address the fundamental issues of entitlement spending and tax reform. (David Stockman, a former Director of the Office of Management and Budget, characterized the deal this morning on CNBC as not only kicking the proverbial can down the road, but launching the can into "low earth orbit".)  Perhaps it is all we could reasonably expect in the current environment of a highly politicized Congress and a dearth of presidential leadership. Thinking of the deal as a breakthrough merely indicates how dysfunctional Washington has become.

If the US budget deal is at very best modest, the blueprint coming out of Brussels is anything but. A joint rescue plan for eurozone banks has been talked about almost since the financial crisis began, given that it was bank failures especially in the UK, Ireland and Spain that sparked the crisis. Finance ministers have engaged in marathon talks to bring it about. Under the plan, to be finally decided next week, a new EU agency, the Single Resolution Mechanism (SRM), would be launched in 2016, and developed over ten years with the emergence of pan-European, not national, funding of up to 55 billion euros. This would be the companion agency to the Single Supervisory Mechanism (SSM) scheduled to begin next year, giving the European Central Bank the authority to monitor the activities of all major eurozone banks. The third pillar for eurozone banks, also in the planning stage, would be a joint guarantee program for depositors, replacing the current scheme operated by respective national authorities. Banking union in Europe, which some see as epochal as the launch of the euro, has barely begun, and it will be years before it is complete, especially given German caution. But a bank rescue scheme like SRM is a significant, necessary step forward; rigorous stress tests of Europe's 130 largest banks next spring will show just how necessary.

News from Nusa Dua

From the tourist enclave of Nusa Dua on the Indonesian island of Bali comes an agreement, approved yesterday, that will almost certainly spark widespread dissent at it is implemented throughout the world. This is because the "Bali Package" strikes a blow to those who view globalization as something to be stopped, and instead renews the world's commitment to the multilateral liberalization of international trade.

All 159 members of the World Trade Organization (WTO) agreed on Saturday to a package of trade measures that Washington's Peterson Institute of International Economics estimates will inject just short of $1 trillion into the world economy while creating 21 million jobs, the bulk in developing countries. The deal, though a very modest start, and far less ambitious than originally conceived, is a milestone. It's the WTO's first, after 12 years of fruitless negotiations, slashing customs' red tape and lowering other non-tariff trade barriers. In a single sweep, it rescues the WTO from irrelevance.

The process of world trade liberalization was not dead, but since the collapse in Geneva of the WTO's Doha round of trade talks just months prior to the Lehman collapse in 2008, it had clearly slowed, and in some ways was reversing into creeping protectionism. Not close to the extreme economic isolationism that emerged in the Depression of the 1930's, a clear pattern of more national self-interest and state intervention in the flow of money and goods was nonetheless developing. Thus, for example, in recent years India has imposed local-content requirements on government purchases of communications technology, Brazil has tightened restrictions on its state-controlled Petrobas to ensure it purchases more of its equipment from Brazilian companies, and both America and Europe have offered substantial subsidies for green energy at home while imposing tariffs on Chinese solar panels, citing Chinese government support of their domestic producers. Further, in a grievous example of confusing the benefits of trade with foreign policy, President Obama decided that the way to respond to the tragic collapse in April of a clothing factory in Bangladesh, killing more than 1,000 people, was to suspend US preferential tariffs on many imports from that country. And, in addition to restrictions on trading goods, controls on cross-border flows of capital, direct investment, and even people, have become more prevalent.

So, into this deteriorating trade policy environment, recently characterized by, at best, a shift to more bilateral and regional agreements, comes the new multilateral Bali package. It's modest, but still remarkable - to think that, when national governments are often trapped in their own political deadlocks, 159 foreign ministers could agree on any sort of package of international trade liberalization measures that apply to them all equally. Allowing markets, rather than government edict, to more freely channel scarce capital to the best investment opportunities is a certain way to enhance economic well-being. In this spirit, let's hope that the WTO can now move the much broader Doha agenda forward.