Attempting to renegotiate the North American Free Trade Agreement (NAFTA) from a protectionist point of view – as US President Donald Trump has suggested doing – will have only destructive consequences. Costs will go up, with the results borne by companies and citizens. Competitive advantage will dip. And overall wealth will fall in most sectors and regions in Canada, Mexico and the United States.

So how can we make NAFTA work? By modernizing it. That means transforming NAFTA into an agreement that reflects the major trends in business and economics, including technological advancements, digitization, labor, and the environment.

Tariffs would have a damaging effect

Free trade in NAFTA has truly been a win-win-win for the NAFTA countries. For example, US foreign direct investment in Mexico has reached $244 billion since 1990, a large share of which has been channeled into building and consolidating US cross-border supply chains. In other words, much US investment in Mexico has been converted into production for US exports. Meanwhile, beyond the wealth creation opportunity, Mexico has embraced a global frame of mind, with functional institutions and a set of rules that foster transparency.

Tariffs would threaten this equilibrium in almost all directions. Costs would rise. In a scenario where NAFTA countries shift to the most favoured nation (MFN) tariffs of the World Trade Organization, there would be an increase in costs that would almost undoubtedly either lead to more expensive goods for consumers in importing countries or reduce exports and hurt local producers in exporting countries.

For Mexico, a tariff increase on exports to the United States would create a loss of about 63,800 jobs and 0.4% of GDP for every 10-percentage-point increase in tariffs. The domino effect would be dramatic – a likely increase in exchange rates, leading to higher prices, higher inflation and a greater distortion in wealth distribution. On the flip side, MFN tariffs would have an especial effect in states like Texas (0.17 percent drop in GDP), Iowa (-0.15 percent), and Nebraska (-0.14 percent).

Regional competitiveness at stake

It is impossible to ignore the US trade deficit, worth about 3% of GDP, which has led to some real financial imbalances, as the deficit has not been funded by net financial inflows. A stronger dollar has led to large foreign holdings of US dollars and securities. And this strong dollar has led to exaggerated optimism, reflected in higher credit levels and rising asset prices (mainly stocks and real estate) – conditions similar to those that led to the 2008 downturn. Any unanticipated event that raises uncertainty may lead to panic, with a reduction in the required flow of resources and an economic crisis that would transmit directly to NAFTA partners.

On top of that the United States’ huge deficit with China – and China’s equally sizable holdings of US currency and securities – creates dangerous conditions for the NAFTA region if it goes down the path of a protectionist trade war, as an already strong Chinese economy would become even more cost competitive globally.

A container ship is docked at the Port of Oakland in California
Image: REUTERS/Beck Diefenbach

Building a stronger NAFTA

A balanced and creative approach to reduce the US trade deficit and the strength of the dollar is necessary to reduce the risks of the current financial imbalances. This will bring a sustainable flow of resources, improving the balance among the relative prices of assets, and avoiding a potential financial and economic crash.

Enhancing technological transfer and tri-national integration in human capital, energy, the environment, and other relevant areas will create a wealth-generating and globally competitive region.

The regional integration of these factors of production would create complementary strengths for NAFTA countries, boosting productivity in a sustainable way with a common approach and improving their wealth creation.