Low Mexican Wages, U.S. Trade Deficits, and NAFTA

Introduction

Wages in Mexico are only one-eighth to one-quarter of U.S. levels.[1]  Because of this wage differential, many Americans believe that NAFTA is killing hundreds of thousands of American jobs and is driving wages for the remaining jobs down towards Mexican levels.[2]

Some go on to suggest that, unless we can get the Mexican Government to sign a revised NAFTA agreement with a clause that forces it to make Mexican companies to pay wages closer to U.S. levels, we should terminate NAFTA and wait until a better wage parity between Mexico and the United States has been achieved. This would be a serious mistake for the following reasons:

• First, the Mexican government is highly unlikely to sign a binding agreement with enforceable sanctions that would obligate it to make private Mexican enterprises to pay wages well above prevailing Mexican market wage rates.
• Second, and far more important, global data on U.S. bilateral trade deficits and on wages in partner countries indicate no significant connection, either in the past or today, between low foreign wages and U.S. trade deficits. 
• Third, while low foreign wages and U.S. bilateral trade deficits do occur simultaneously, the cause of the deficits lies not in the low wages but elsewhere. Killing NAFTA would probably not end these trade deficits. Instead, it would destroy jobs on both sides of the border as supply chains dependent on cross-border trade collapse. In fact, the trade deficit could become even worse if, as is likely, NAFTA’s caused the peso’s collapse, making Mexican goods even cheaper.

No real connection between low foreign wages and U.S. trade deficits

Between the end of World War I and the second OPEC Oil Crisis, virtually all of America’s trading partners had incomes lower than those in America.[3]  If low wages drive trade deficits, America should have suffered substantial deficits during these years. However, the reality was far different. America had a current account surplus, or a deficit less than one-half percent of GDP, in fifty-nine of those sixty-five years! In the other years, events such as the Great Depression, WWII, and increased oil prices – not wage differentials – clearly caused the deficits.

Country-specific data for the past quarter century likewise undermine the assumption that trade with low-wage countries causes trade deficits. Were this true, we should see a consistent pattern across U.S. trading partners of large bilateral trade deficits with low wage countries, and small bilateral trade deficits, or even trade surpluses, with high-wage countries.

However, consider Figure 1, which is based on data for thirty-five OECD and BRIC countries. The countries are ranked along the horizontal axis by wages and along the vertical axis by bilateral trade deficits.[4]

Figure 1. Low Foreign Wages Not the Real Cause of U.S. Trade Deficits

This figure demonstrates beyond all reasonable doubt that low foreign wages do not explain bilateral U.S. trade deficits. If they did, the data points would cluster tightly along the trend line. Furthermore, bilateral trade deficits would increase as we move from high-wage countries like Australia, Switzerland, and Iceland on the left to low-wage countries like China, Mexico, and Brazil on the right.

Instead, the data points show virtually no correlation between wage levels and bilateral U.S. trade deficits. In fact, the r-squared is only 0.023, indicating that barely over two percent of U.S. bilateral trade deficits can be explained by low wages in partner countries.

Country detail is also important. America’s largest bilateral trade deficits (towards the top of the chart) are with relatively poor countries like China, Mexico, and India to the right side– but also with relatively rich countries like Canada, Japan, and Germany to the left. 

Conversely, America’s smallest bilateral trade deficits, which appear towards the bottom of the chart, are with relatively rich countries like Australia, Belgium, and the Netherlands to the left – but also with relatively poor countries like Brazil, Turkey, and Chile to the right.

It is worth mentioning that our two NAFTA partners – Canada and Mexico – are both high on the vertical deficit scale, but are near opposite ends of the horizontal wage rate scale.

Note also that membership in free trade zones seems to be largely irrelevant to trade deficits. Although Canada and Mexico lie close to the top of the U.S. trade deficit scale, so do Japan, Germany, and China.

Conclusions: We should not base recommendations regarding NAFTA’s future on the assumption that Mexico’s low wages make large U.S. bilateral trade deficits inevitable. 

We must also conclude that factors other than low wages are the primary determinant of bilateral U.S. trade deficits. These factors, which should be our policy focus, will be discussed in a forthcoming blog.

John R. Hansen
September 25, 2017
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Notes:
[1] The international wage data in this note, which cover OECD and BRIC countries, come from the Organization for Economic Cooperation and Development. The data on America’s bilateral trade deficits come from the U.S. Census Bureau.
[2] See, for example, Scott, 2017.08.21, Renegotiating NAFTA Is Putting Lipstick on a Pig.
[3] Based on data from Maddison on per capita GDP income data in International (PPP) Dollars. Because wages and GDPpc income correlate well, we can assume that GDPpc is a reasonable proxy for wages. American GDPpc was a bit lower than in a few other countries like Switzerland and the UK during the Great Depression. And since the 1950s, certain oil-producing countries in the Arabian Gulf have had higher levels of GDPpc. These were the only significant exceptions until recent years when certain financial centers – often islands and small city states serving as tax havens – began to have incomes higher than those in America.

[4] The figure uses rank correlations rather than raw data because the dispersion of raw values between rich vs. poor, and small vs. large countries is so extreme that such data make it virtually impossible to see underlying patterns. The rank ordering is as follows. For data on America’s bilateral trade deficits, countries are ranked from smallest deficit (or largest surplus) to largest deficit; Netherlands is #1 on this scale and China is #35. (Note that the U.S. has had an average trade surplus since 1990 with the Netherlands and the other seven countries in the graph up to and including Iceland.) The wage data for Figure 1 is ranked from high to low with Switzerland as #1 and India as #35.

[5] For perspective, America’s comparable average wage figure on $52,272 for the period would place it between Denmark and Norway on the chart.

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